CPA PROGRAM

FINANCIAL RISK
MANAGEMENT

Version 15a
 FINANCIAL RISK MANAGEMENT

Contents
Subject outline 1

Module 1: Introduction to financial risk management 13

Module 2: Management of liquidity, debt and equity 85

Module 3: Investment evaluation and capital structure 155

Module 4: Derivatives 225

Module 5: Interest rate risk management 269

Module 6: Foreign exchange and commodity risk management 331

Module 7: Accounting for derivatives and hedge relationships 397

Module 8: Controlling risks 465

 FINANCIAL RISK MANAGEMENT

Subject outline
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OUTLINE

Contents
Introduction 3
Before you begin 3
Important information
Subject description 3
Financial Risk Management: The CPA as the guardian
Subject aim
Subject overview 4
General objectives
Module descriptions
Module weightings and study time requirements
Learning materials 6
Module structure
Exam 9
General information
Exam structure
Authors 10
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Introduction
The purpose of this subject outline is to explain:
• provide important information to assist you in your studies;
• the aims and content of the subject;
• how the subject will operate; and
• the assessment requirements.

Before you begin

Important information
Please refer to the CPA Australia website, cpaaustralia.com.au/cpaprogram, for the CPA Program
dates, contacts, regulations and policies, and additional learning support options.

Subject description
Financial Risk Management: The CPA as the guardian
High levels of debt exist across the world following the Global Financial Crisis, combined
with slow economic growth has created a volatile global economic environment. As a result,
organisations are vulnerable to financial risk, including funding and liquidity risk, market risk from
interest rate, exchange rate or commodity price movements, credit risk and operational risk.
The purpose of this subject is to equip you with the necessary skills to assess these financial risks
and manage them strategically with the use of financial instruments.

The Financial Risk Management subject extends the governance framework covered in the
Ethics and Governance subject, further discusses the process of investment evaluation that was
covered in the Strategic Management Accounting subject, and examines some of the practical
elements and complexities of hedge accounting in relation to the international financial reporting
standards that were covered in the Financial Reporting subject.

Subject aim
The aim of this subject is to develop an understanding of, and the skills required to apply,
appropriate financial risk management strategies to address an organisation’s financial risk.
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Subject overview
General objectives
On completion of this subject, candidates should be able to:
• understand risk and a risk management framework
• identify the types of financial risk faced by an organisation;
• apply a practical approach to assessing, monitoring and managing an organisation’s
financial risk;
• understand the funding, liquidity, interest rate, foreign exchange, commodity price,
credit and operational risk faced by organisations;
• advise an organisation on the procurement and management of funding and the allocation
to competing long-term investments;
• understand the nature and characteristics of derivatives;
• advise an organisation on the types of financial instruments that could be used to best
manage an organisation’s financial risk;
• demonstrate the practical elements of accounting for derivatives for both embedded
derivatives and derivatives used for hedging purposes; and
• explain responsibilities for financial risk and regulatory requirements, and the control
framework for managing both financial and operational risks.

Module descriptions
The subject is divided into eight modules. A brief outline of each module is provided below.

Module 1: Introduction to financial risk management

Module 1 presents an introduction to risk generally in organisations and a risk management
framework. Such frameworks are used in many organisations and provide the principles and
methodology by which to understand financial risk management. Financial risk management is
defined together with an explanation of the important role of accountants in both understanding
and managing financial risk. The methodology and concepts introduced in this module will be
expanded upon throughout the subject.

Module 2: Management of liquidity, debt and equity

This module examines the procedures involved in liquidity, working capital and funding
management. The various debt and equity markets are explained with reference to organisational
funding needs and suitability. The listing requirements of the Australian Securities Exchange are
also discussed.

Module 3: Investment evaluation and capital structure

Module 3 develops a risk manager’s understanding of capital budgeting techniques and how
an organisation should allocate its funds to competing long-term investment opportunities.
Also discussed is the cost of capital and funding mix to ensure the organisation’s activities are
financed at an acceptable cost with a managed level of risk.

Module 4: Derivatives
An organisation’s financial risk can be managed with the use of financial instruments such as
forwards, futures, swaps and options. These derivative products can be used to alter both
the nature and timing of interest rate, foreign exchange and commodity price exposures.
This module introduces the main types of derivatives and the associated benefits and drawbacks
of each. The strategic application of these financial instruments to interest rate risk is covered
in Module 5, and to foreign exchange and commodity price risk in Module 6.
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Module 5: Interest rate risk management
Strategic and operational interest rate risk management is a core skill of a corporate risk manager.
The Global Financial Crisis of 2007–09 resulted in many corporate failures, and management can
no longer claim ignorance of the dangers inherent in exposure to interest rate volatility or of the
techniques for its management. This module explores the fundamental processes of interest rate
risk management and its interrelationship with liquidity management and solvency.

Module 6: Foreign exchange and commodity risk management

Strategic and operational foreign exchange and commodity risk management is also a
core skill of a corporate risk manager. The key drivers that affect currencies and commodity
prices are examined and the organisation’s exposure determined. Strategic management
of these exposures is achieved through the use of financial instruments and best risk
management practice.

Module 7: Accounting for derivatives and hedge relationships

Following on from the three previous modules which discuss the nature, use and management of
derivatives, this module provides the accounting rules and examples for derivatives and hedge
relationships as well as the interaction with the accounting for foreign currency transactions.
Key areas covered include; accounting for embedded derivatives, hedge accounting and the
new hedge accounting model under IFRS 9.

Module 8: Controlling risks

This module expands on the risk management framework discussed in Module 1 by focusing
on the responsibilities within organisations for risk management and controls, regulatory
requirements and monitoring expected to manage financial risks. As a key control, the module
explores the contents of a financial risk policy and also considers operational risks associated
with a treasury operation and the essential operational controls to be implemented.

Module weightings and study time requirements

Total hours of study for this subject will vary depending on your prior knowledge and experience
of the course content, your individual learning pace and style, and the degree to which your
work commitments will allow you to work intensively or intermittently on the materials. You will
need to work systematically through the study guide and readings, attempt all the in-text and
online self-assessment questions and any case studies, and revise the learning materials for the
exam. The workload for this subject is the equivalent of that for a one semester postgraduate
unit. An estimated 10 to 15 hours of study per week over a 12-week period will be required for an
average candidate before revision.

Do not underestimate the amount of time it will take to complete the subject.

The ‘weighting’ column in the following table provides an indication of the emphasis placed
on each module in the exam, while the ‘proportion of study time’ column is a guide for you to
allocate your study time for each module.
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Table 1: Module weightings and study time

Recommended
proportion
of study time Weighting Study
Module (%) (%) schedule

1. Introduction to financial risk management 10 10 Weeks 1, 2

2. Management of liquidity, debt and equity 14 14 Weeks 2, 3

3. Investment evaluation and capital structure 10 10 Weeks 4, 5

4. Derivatives 10 10 Weeks 5, 6

5. Interest rate risk management 14 14 Weeks 6, 7

6. Foreign exchange and commodity risk management 14 14 Weeks 7, 8, 9

7. Accounting for derivatives and hedge relationships 14 14 Weeks 9, 10

8. Controlling risks 14 14 Weeks 10, 11

100 100

Learning materials
Module structure
These study materials form your central reference in the Financial Risk Management subject.

Contents
Each module has a detailed contents list. This list indicates the sequence of the educational
content in the module.

Preview
Each module begins with a preview containing the following sections.

Introduction: The introduction outlines what will be covered in the module and how it relates
to other modules in the subject.

Objectives: A set of objectives is included for each module in the study guide. These objectives
provide a framework for the learning materials and identify the main focus of the module.
The objectives also describe what candidates should be able to do after completing the module.

Teaching materials: This section alerts you to the required teaching material (if any) to which you
should have ready access. It also includes a list of readings which are to be used in conjunction
with the module study material.

Study material
The study material is divided into sections and subsections which will help you to conceptualise
the content and study it in manageable portions. It is also important to appreciate the cumulative
nature of the subject and to follow the given sequence as closely as possible.
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Study material activities
Activities are included throughout the study material. The study material includes three
distinctive types of activities:
• revision questions;
• reflective questions; and
• case studies.

The purpose of the questions and case studies is to provide you with the opportunity, as you
progress through the subject, to assess your understanding of significant points and to stimulate
further thinking on particular issues. The self-assessment activities are an integral part of your
study and they should be fully utilised to support your learning of the module content throughout
the semester. You are encouraged to spend time reviewing and analysing the module content.
Utilising the self-assessment activities should form one part of your revision for the exam. It is
evident that candidates who achieve good results in the program and in their careers are those
who are able to think, review and analyse situations, and solve problems.

Where applicable, sample answers are included at the end of each module. These provide
immediate feedback on your performance in comprehending the material covered. Your answers
to these questions do not contribute to your final result, and you are not required to submit
your answers for marking.

Revision questions. These require you to prepare answers and to compare those answers with
the suggested answers before continuing with the study material. These questions test your
comprehension of specific sections of a module.

Reflective questions. These require you to reflect on an issue. They are not numbered,
and are set in bold italics. No suggested answers are provided for these questions.

Case studies. These are much broader in scope than revision and reflective questions.
They illustrate practical problems which might be faced by accountants. The case studies
require you to apply the theoretical knowledge you studied in the module to a particular
situation. To be able to adequately address issues raised in case studies, a deep understanding
of the module content is required. Simply memorising definitions and lists of technical details
is insufficient.

While issues may be relatively clear in some case studies, it is important to realise that often
the case studies will have no correct/incorrect outcomes. The outcomes are quite possibly best
expressed as different viewpoints on problem situations, where viewpoints are supported by
reference to relevant theoretical principles. Moreover, the essence of the case may depend
on interpretation of the relevant concept rather than a simple restatement of that principle or
concept. For this reason, solutions to case studies are not always provided. Instead, responses
to cases are included in comprehensive case notes. To obtain maximum benefit from your case
study work, and to provide the best preparation for the case study section of the subject exam, it
is important to allow adequate time for in-depth analysis of case studies and that you thoroughly
work through case materials and prepare an extended response to case issues before you check
your responses against the notes/answers provided.

Review
The review section places the module in context with other modules studied and summarises
the main points of the module.
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References
The reference list details all sources cited in the study guide. You are not expected to follow up
this source material.

Optional reading
The resources in the ‘Optional reading’ list are useful if you wish to explore a particular topic in
more detail.

Required readings
Readings are provided to assist in the clarification and application of concepts from the study
materials. The content of readings is not directly examinable. However, the concepts covered by
the readings are examinable.

Suggested answers
These provide important feedback on the numbered revision questions and case studies
included in the module learning materials. Consider them as a model for your reference.
To assess how well you have understood and applied the material supplied in the text, it is
important to write your answer before you compare it with the suggested answer.

Internet references
At various points in the subject materials you may be directed to references located on the
internet, and many of these are on external websites. All the URL addresses cited are tested
prior to the start of the semester to ensure their currency; however, this does not guarantee that
changes have not been made to the websites since the tests were performed. CPA Australia
provides links to external websites as a service to candidates in the CPA Program. CPA Australia
does not own, operate, sponsor or endorse these external websites and makes no warranties or
representations regarding the source, quality, accuracy, merchantability or fitness for purpose of
the content of these external websites; nor warrants that the content of these external websites
is free from any computer virus or other defect or error.

My Online Learning
CPA Australia offers additional study material through My Online Learning to assist candidates in
their study. Some of the content on My Online Learning is examinable, including any study guide
updates which will be posted here. You can access My Online Learning from the CPA Australia
website—details are provided below.

How to access My Online Learning:

1. Go to: cpaaustralia.com.au/myonlinelearning
2. Click Access My Online Learning
3. Enter your member number in the username field and password and click ‘Login’

There is also a demonstration video to assist you in navigating the system.

To access the study groups function, click ‘My Study Groups’ next to ‘My Courses’ in the top
banner, then select the relevant subject using the dropdown box next to ‘Course’.
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Help Desk—for help when accessing My Online Learning either:
• Email myonlinelearning@cpaaustralia.com.au; or
• Telephone 1300 73 73 73 (Australia) or +613 9606 9677 (International) between 8.30 am
and 5.00 pm AEST Monday to Friday during the semester.

The additional study materials provided on My Online Learning include:

• Discussion forums—these enable you to post any questions you may have about the
technical content of the subject.
• Calendar—keep track of important dates and events.
• Web links—access useful online resources including legislation and standards where relevant.
• Announcements—you should check My Online Learning at least once a week as important
information and critical study information will be posted there.
• Limited PDF versions of modules—modules covering approximately the first two weeks of
the syllabus are available to assist candidates that may not receive their study materials in
time for semester commencement. The PDF modules are the same as the printed modules;
however, the third-party copyright is removed. Note: The PDF modules are not available for
Singapore Taxation.
• Learning tasks—online activities that help you understand or practise particular concepts
covered in the subject.
• Electronic self-assessment tests (e-SATs)—access exam practice questions to assist in your
revision and to help you become familiar with the style and presentation of multiple-choice
questions. The level of difficulty of the practice questions is not equivalent to those in the
exam and are not available for all subjects.
• Online readings—readings and journal articles may be available via ProQuest.
• Study groups—candidates who wish to participate in group discussion can join a study
group through My Online Learning. Study groups provide candidates with access to a secure
online list of email contact details for other candidates who are studying the same subject
and who have also registered for a study group. Candidates can use these contact details to
form their own study groups.

Exam
General information
CPA Program exams are of three hours and 15 minutes duration.

The exam for Financial Risk Management is open book. This means that candidates may bring
any reference material into the exam which they believe to be relevant and which may assist them
in undertaking the exam. This may include, for example, the study guide, additional materials
from My Online Learning, readings and prepared notes.

It is highly recommended that all candidates have access to a calculator in the exam. Please ensure
that the calculator is compliant with CPA Australia’s guidelines. The calculator must be a silent
electronic calculating device whose primary purpose is as a calculator.

Calculators with text-storing abilities are not permitted in the exam.

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The exam is based on the whole subject, including the general objectives, module objectives and
all related content and required readings. Where advised, relevant sections of the CPA Australia
Members’ Handbook and legislation are also examinable.

As this exam forms part of a professional qualification, the required level of performance is high.
Candidates are required to achieve a passing scaled score of 540 in all CPA Program exams.
Further information about scaled scores and exam results is available at: cpaaustralia.com.au/
cpa-program/exam-results

Exam structure
The Financial Risk Management exam is comprised of 100 per cent multiple choice questions.
Multiple choice questions include knowledge, application and problem solving questions which
are designed to assess the understanding of Financial Risk Management principles. Table 1
provides an indication of the approximate proportion of your study time which should be
allocated to each of the modules.

Authors
Richard Allan
Richard is a financial strategy advisor specialising in financial
diagnostics for boards and senior executives.

Richard’s main expertise is in the corporate sector. He has

managed capital, currency and commodity exposures
including coal, iron ore, aluminium and oil and gas, and has
had experience with all major facets of financial operations.
His roles within major banks have included Australian
Treasurer—Corporate Financial Management and Director and
Vice-President in the Treasury and Capital Markets area of the
then world’s largest financial institution. He has also advised
many federal government departments and for many years
was Director and Associate Professor for postgraduate finance
programs in Australia and Asia for a leading Australian university.

Richard is currently the Managing Director of Applied Financial

Diagnostics, which provides strategic financial services and
analytics, mainly to Chief Executive Officers.
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Michael Heffernan
Michael has over 29 years’ experience in the finance and
securities industry and is currently a Senior Client Adviser and
Economist with Lonsec Limited Sharebrokers, a dynamic player
in the Australian finance and securities industry, with a focus
primarily on the success of the individual and retail investor.
In his current position with Lonsec, Michael is involved with
analysing developments in the Australian economy and major
overseas markets, and translating these trends into opportunities
in the Australian sharemarket.

Prior to joining Lonsec, Michael was employed as an Economist

with the Commonwealth Department of Employment before
beginning his period as Chief Economist/Lawyer with the
Australian Stock Exchange.

In addition to memberships of legal, economic and securities

industry associations, Michael is heavily involved in the
educational side of the industry. In this respect, he is a Fellow,
Councillor, life member and past Chairman of the Financial
Services Institute of Australasia (FinSia) in Victoria. He is also
Chairman of the ‘Task Force’ for the subject ‘Financial Markets
and Economics’, included in Kaplan’s (formerly FinSia’s) Masters
degree of Applied Finance and Investment.

Michael is also a sought-after speaker and media commentator

on investing in the sharemarket and its interaction with the
economy and, in this respect, he regularly talks with various
investor, community and professional groups. In June 2013
Michael received the award of ‘Stock picker of the year 2013’
from the Australian Stockbrokers Foundation.

Asjeet S. Lamba
Asjeet is an Associate Professor with the Department of Finance
at the University of Melbourne. Asjeet has an MBA in Finance
from the University of Michigan and a PhD in Finance from
the University of Washington. His main teaching and research
interests are in corporate finance and international finance.
His research has been published in several leading academic
journals and he regularly presents his on-going research
at academic and professional conferences. Asjeet is also a
CFA charter holder.
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Peter Humphrey
Peter is a financial market risk specialist with a background in
financial markets and technology. Following a period of time
spent in information systems at Bill Acceptance Corp and
Midland Bank he joined Union Bank of Switzerland, first as the
IT Manager and then in the trading room where he established
and ran the foreign exchange option book. He then moved on
to set up the market risk oversight section, or Treasury ‘middle
office’, at UBS. These were the formative years for these internal
risk control functions in the banking industry and Peter was one
of the pioneers in this area in Australia.

Peter then spent four years in Singapore with UBS as the

regional head of Treasury Information Technology.

Over the last 10 years, since moving back to Australia, Peter has
been a founding director in a boutique funds management
company, the director of a financial systems provider and has
undertaken a diverse range of financial market risk management
consulting assignments. He has spent the majority of the last
18 months at CSR, in Treasury middle office.

John Kidd
John currently works as a consultant in the area of accounting
and financial risk management. Previously he was a Partner in
the Deloitte Financial Services Group for 15 years up until 2013,
having spent his professional career of 29 years specialising
in accounting for financial instruments (including hedge
accounting), funds management, financial/operational risk
management and compliance. Prior to Deloitte, John worked
at a Japanese trading house assisting with imports/exports,
interest rate and FX risk management. John currently works
as a consultant in the area of accounting and financial risk
management.

Brett Dobeson
Brett is the Head of Counterparty Credit Risk at National
Australia Bank, responsible for all aspects of derivative
counterparty credit exposure management, including CVA,
collateral management, central clearing (CCPs) and related
funding and regulatory issues. Previously Brett was the global
head of FX and Commodity Market Risk at NAB and has
over 20 years’ experience in treasury, risk management and
investment banking. Brett joined NAB in 2007 to manage the risk
function in relation to NAB’s foreign exchange and commodity
global trading books. He has worked extensively outside
Australia, including Singapore, London and New York.
 FINANCIAL RISK MANAGEMENT

Module 1
INTRODUCTION TO
FINANCIAL RISK MANAGEMENT
RICHARD ALLAN AND JOHN KIDD
 14 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Contents
Preview 15
Introduction
Objectives
MODULE 1

Teaching material
Introduction to risk 16
Risk defined
Financial risk
ERM framework 17
Risk management
Principles of risk management
Elements of the framework
The risk management process
Establish the context
Assess risk
Treat risk
Communicate and consult
Monitor and review
Level of sophistication 42
Risk framework
Risk matrix
Financial risks 43
Financial risks defined
Accountants and financial risk
Approach models with caution
Risk appetite in the context of financial risks
Functional currency
Treasury function
Performance measurement in the context of FRM
Financial risk in different industry sectors 52
Parallel universes: Bank and corporate treasury operations
The framework for FRM 56
Identifying financial risk and opportunity in an organisation
Review 65
Glossary of statistical terms 66
Key statistics and useful Excel formulas

Reading 69
Reading 1.1 69

Suggested answers 75

References 83
Optional reading
 Study guide | 15

Module 1:
Introduction to

MODULE 1
financial risk management
Study guide

Preview
Introduction
As the word ‘risk’ has both positive and negative connotations, the approach taken in this subject
is to systematically identify risks so that opportunities can be exploited and threats controlled.

The Financial Risk Management subject is designed to prepare you to identify and manage the
financial risks associated with organisations in order to achieve the organisation’s strategic goals.

Financial risk is just one of the areas of risk that has to be managed within an organisation.
There are also other areas of risk, such as legal, environmental and labour risk. The management
of total business risk is generally referred to as enterprise risk management (ERM). Financial risk
management (FRM) is effectively a subset of ERM that sits within the ERM framework and often
interacts with other types of business risk.

This subject presents concepts in an applied manner to ensure that the risk management
process and the accounting treatment of FRM are related to real-life situations for both small
and large organisations.

Module 1 presents an introduction to risk and the risk management processes and should be
read as preparation for more detailed study in later modules. The concepts introduced here will
be augmented in Modules 2 to 6 by a detailed explanation of the FRM techniques commonly
used in the management of financial exposures. As derivatives are commonly used in the
management of certain financial risks, these are specifically explained in Module 4. The use of
derivatives is then explored in the context of interest rate risk in Module 5 and foreign exchange
and commodity risk in Module 6. The complex area of accounting for derivatives and hedging is
then covered in Module 7.
 16 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

The Module 1 treatment of business risk and discussion of a framework for managing business
risk should be read as an introduction to Module 8, ‘Controlling risks’. Regardless of how well
risks are identified, analysed and managed (Module 1), without adequate and effective controls
(Module 8), organisations remain vulnerable to potentially terminal losses from accidental or
deliberate breaches of policies and procedures.
MODULE 1

Both Modules 1 and 8 take account of the ASX Corporate Governance Council’s Corporate
Governance Principles and Recommendations (ASX CGC 2014) (ASX Principles). While the
recommendations in the ASX Principles are not mandatory for organisations listed on the ASX,
their application is strongly encouraged through an ‘if not, disclose why’ regime (ASX Listing
Rule 4.10.3). In particular, Principle 7, ‘Recognise and manage risk’ needs to be understood by
ASX-listed entities. This principle recommends that listed entities have a sound risk management
framework and periodically review the effectiveness of the framework. It also recommends that
listed entities inform investors when there is a material exposure to economic, environmental or
social sustainability risks and if so how these are managed.

Objectives
By the end of this module you should be able to:
• explain and apply the definition of business risk;
• apply the framework for managing risk;
• explain the impact of the external environment on risk;
• explain risk appetite in the context of financial risks;
• explain how the risk appetite is established for an organisation;
• explain financial risk and the importance of financial risk to accountants;
• explain the different nature of financial risks in different organisations and industries; and
• apply the financial risk concepts of risk appetite, risk identification and risk matrix
to a simple example.

Teaching material
• Reading
Reading 1.1
‘AWA and foreign exchange exposure management’

Introduction to risk
Risk defined
Business risk in its broadest sense is defined as anything that will prevent the organisation from
achieving its objectives. Under the Australian and international standard on risk management,
AS/NZS ISO 31000:2009 Risk management—Principles and guidelines, ‘risk’ is defined as the
‘effect of uncertainty on objectives’. Hence risk can be considered to be:
• a deviation from the expected result—positive or negative; and
• as broad as the organisation’s objectives; for a human resource department it may relate
to quality of candidates recruited.

Risk management in many organisations is often seen as a negative—to restrict certain actions.
But this is a misconception as it is accepted in business that it is essential to take risks to make
profits. The governance of risk and value creation should therefore be considered as one and
the same thing.
 Study guide | 17

Every decision, activity and initiative that aims to create value has a degree of risk. Accordingly,
risk management is about understanding the material risks faced by the organisation, and ensuring
that they are appropriately managed in line with the board’s risk appetite. Hence rather than being
risk averse, organisations should strive to be risk-intelligent.

MODULE 1
The focus of this module is on FRM. As FRM is a component of the broader ERM framework,
our study of FRM will be based on a general ERM framework.

Financial risk
Financial risk is defined as any financial related matter (see list as follows) that the will prevent the
organisation from achieving its objectives. Financial risks are typically analysed into the following
seven categories:
1. liquidity risk;
2. funding risk;
3. interest rate risk;
4. foreign exchange risk;
5. commodity price risk;
6. credit risk or counterparty risk; and
7. associated operational risk.

These financial risks will be defined and discussed later in the module.

ERM framework
Risk management
There are many frameworks for risk management in use around the globe. Some FRM/ERM
systems lean toward financial reporting and internal control, while others focus on management,
corporate governance, and accountability.

Three of the key standards which provide useful frameworks for risk management are
described below.

1. Australia and New Zealand’s AS/NZS ISO 31000:2009 Risk Management—Principles and
Guidelines (the Standard). This international standard is general in nature, covering all types
of risk, including commercial, financial, operational and environmental. The standard can be
applied to both the upside and downside of risk (opportunities and threats) in any type of
organisation and to any project or product. Its objective is to provide a basis for decision-
making, risk identification, value enhancement, resource allocation and corporate governance.

2. The UK Risk Management Standard (RMS), issued by the Federation of European Risk
Management Associations (FERMA) in 2002, a consortium of UK organisations including
the Institute of Risk Management, the Association of Insurance and Risk Managers, and the
National Forum for Risk Management in the Public Sector. The RMS represents best practices
including linking risk to the organisation’s strategic objectives, risk assessment, analysis,
identification, estimation and evaluation.

3. The US Committee of Sponsoring Organizations of the Treadway Commission (COSO) guide,

Enterprise Risk Management—Integrated Framework (2004). This framework defines essential
enterprise risk management components, discusses key ERM principles and concepts,
suggests a common ERM language, and provides clear direction and guidance for enterprise
risk management. The guidance introduces an enterprise-wide approach to risk management
as well as concepts such as risk appetite, risk tolerance and portfolio view. This framework
is now being used by organisations around the world to design and implement effective
ERM processes.
 18 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

In this module we focus on AS/NZS ISO 31000:2009 Risk Management—Principles and Guidelines.
This standard consists of three components:
1. Core principles to be followed.
2. A general framework.
3. A process for risk management.
MODULE 1

The purpose of following such a standard is that it ensures risk is consistently managed across
the organisation, using a robust and efficient process. As a result, the outcomes for an entity
from following such an approach should be to:
• improve the likelihood of achieving its goals;
• encourage risk identification and treatment;
• demonstrate compliance with laws and regulations;
• improve financial reporting;
• strengthen controls;
• improve stakeholder trust and confidence;
• improve internal controls;
• improve the transparency of risks and reporting; and
• assist in the prioritising of effort in the management of risks.

Principles of risk management

There are 11 key principles behind the Standard.
1. Creates value
Any ERM process should add value to the organisation. This will not be the case if the ERM
process becomes bogged down in a box-ticking administration exercise. Intelligent risk
taking must be seen as a valuable part of normal good business practices.

2. Integral part of organisational processes

To be effective, each decision of every person in the organisation must be based on the
principles, framework and process. The goal is to have risk management built into standard
operating procedures.

3. Part of decision-making
Decision-making must factor in risk and the impact it has on the organisation.

4. Explicitly addresses uncertainty

As there is uncertainty in most aspects of an organisation’s activities, the elements of
uncertainty must be specifically considered.

5. Systematic, structured and timely

Risk management should be carried out in a systematic and structured fashion such that it is
consistently applied across the activities of the organisation. It must also be done on a timely
basis—that is, before new activities are initiated so as to be part of the decision to commence
such activities.

6. Based on the best available information

It is expected that staff will use the best available information in making decisions; this requires
keeping up to date with the latest approaches and best practices associated with the activity.

7. Tailored
There is no point having a generic risk management template in place, as every organisation
is different and has its own unique circumstances that need to be addressed.
 Study guide | 19

8. Takes human and cultural factors into account

As all activities are human-initiated and influenced by cultural factors, both aspects should
be taken into account in formulating the entity’s risk management activities.

9. Transparent and inclusive

MODULE 1
Risk management should be transparent to everyone in the organisation such that all
personnel are included in the process.

10. Dynamic, iterative and responsive to change

Risk management must change as the organisation changes over time and faces new risks
and opportunities.

11. Facilitates continual improvement and enhancement of the organisation

For risk management and every other aspect of an organisation, there needs to be a culture
of continual improvement to enhance and streamline risk management practices over time.

Elements of the framework

The risk management framework has the following five elements.

1. Mandate and commitment

The risk management framework should be based on the mandate and continuous
commitment from the board of directors to implement and manage a risk management
framework. Commitment to risk management must be demonstrated from the top down,
through words and actions. Risk management must be provided with adequate resources to
succeed and factored into the appraisal system of staff.

2. Design
The framework must be designed to suit the nature of the organisation. This is a specific skill
requiring practical application of concepts to unique circumstances.

3. Implementation
Management then needs to implement the framework across the organisation. This needs
to be established in a way that ensures:
–– the nature and significance of risk are clear;
–– controls managing risks are articulated;
–– controls are allocated to responsible persons;
–– those persons accept responsibility for monitoring and managing risk; and
–– the status of the implementation in each area is monitored.

4. Monitoring and review

Once the framework is in place, all aspects of the framework should be monitored and
reviewed at each level of management. Line managers should monitor and review their
own areas and communicate results to senior management. The entire risk management
framework should be subject to the risk review by an internal risk or business control
department and by internal and external audit. Ultimately, the results should be
communicated to the board for its review.

5. Continual improvement
It is expected that the risk management framework would change with experience to improve
both the efficiency and effectiveness of the process. A risk framework must be continually
modified to suit the changing nature or structure of the organisation; risks will change,
technology used by the organisation will change and controls will improve. As the entity
acquires new businesses the framework will need to expand to cover the new businesses.
 20 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

The interaction between elements of the risk management framework is shown in Figure 1.1.

Figure 1.1: Risk management framework

MODULE 1

Mandate and
commitment

Design framework
for managing risk

Continual Implement
improvement risk management
of framework

Monitoring and
review of framework

Source: AS/NZS 2009, AS/NZS ISO 31000:2009 Risk Management—Principles and Guidelines, p. vi.
Reproduced with permission from SAI Global Ltd under Licence 1410-c064.

The risk management process

Figure 1.2 outlines the risk management process as described in the risk management standard.

Figure 1.2: Risk management process incorporating communication and consultation

Establishing the context

Risk assessment
Risk identification

Communication Monitoring
and Risk analysis and
consultation review

Risk evaluation

Risk treatment

Source: AS/NZS 2009, AS/NZS ISO 31000:2009 Risk Management—Principles and Guidelines, p. 14.
Reproduced with permission from SAI Global Ltd under Licence 1410-c064.

Many large organisations use this process as a basis for constructing their risk frameworks.
Furthermore, as the same approach is used in deliberations for FRM, it is important that each
aspect of this process is fully understood.
 Study guide | 21

The basic components of the AS/NZS ISO model shown in Figure 1.2 are found in most FRM or
ERM frameworks. The five steps in the model are:
1. Establish the context.
2. Identify risk.
3. Analyse risk.

MODULE 1
4. Evaluate risk.
5. Treat risk.

Around these steps are feedback and control lines to:

• monitor and review; and
• communicate and consult.

We will consider each of these components in the following sections.

Establish the context

In establishing the context it is important to consider external and internal factors affecting the
risk being considered.

External factors
External factors concern industry and broader economic considerations. They include any external
influence affecting the organisation’s ability to achieve its objectives. Below, we focus on economic
conditions faced by all organisations, but external factors could include other influences on the
organisation’s activities, such as:
• technological changes in the products sold;
• competitor activities;
• substitute products;
• social and environmental expectations;
• regulatory changes; and
• key customers.

Global Financial Crisis

FRM policy would pay significant attention to the local and global economic environment and
the lessons to be learnt from the Global Financial Crisis (GFC) in 2007–08. This would include
the repercussions on economic growth, currencies, interest rates, counterparty credit risk,
liquidity and the availability of funding.

Furthermore, it should be recognised that the GFC was not an isolated event. Throughout
history, financial systems have collapsed periodically and will continue to do so. Much like
earthquakes and tsunamis, economic forces may reach a stage of breaking point, followed by
financial upheaval and dislocation.

FRM managers need to understand this and also understand the implications for their own
organisation’s survival and prosperity. Furthermore, crises do not just have negative outcomes:
there are always winners and losers. Warren Buffett famously said ‘After all, you only find out
who is swimming naked when the tide goes out.’ This is very true of risk management practices.
Often the effectiveness of risk management practices are tested when crises occur.

The GFC was so named because of the contagious financial instability that engulfed all the
major economies of the world for years after its 2007 beginnings. The effects of the crisis were
felt through debt, equity, foreign exchange and commodity markets with wild fluctuations in
valuations and pricing. This resulted in a repricing of credit virtually overnight and the withdrawal
of many lines of credit.
 22 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

In effect, there was credit rationing, whereby credit rationed by banks was provided only to those
organisations with better prospects. This meant that highly leveraged organisations struggled to
refinance their credit lines. In addition to the credit rationing, institutional investors such as fund
managers and life insurance companies sold out of bonds and shares and placed their funds in
more liquid assets such as cash.
MODULE 1

In this way, the GFC has served to emphasise the importance of a comprehensive risk
management framework. It also challenged several assumptions that had formerly underpinned
the policies and actions of many organisations. For example, refinancing risk was previously only
a significant concern to poorly performing organisations. However, during the GFC, major listed
property trusts found that they were unable to refinance their debt positions, resulting in a
significant cost to investors. These listed property trusts were well managed Australian Securities
Exchange (ASX) listed organisations that, in the 1990s, had conservative debt balances of 20 to
30 per cent. In a pre-GFC era of cheap and easy money, the debt positions of many listed
property trusts increased to 60 to 70 per cent, based on the assumption that cheap and easy
money was here to stay, with higher debt levels boosting the return for investors. When the GFC
hit, debt funding had to be reduced to conservative levels through rights issues (a form of equity
raising). The trusts raised funds from the market at the same time that their share prices had
dropped to historical lows. Investors who did not have funds to participate in the rights issue—
and hence unable to buy more shares at the lower prices—lost significant value in their equity
positions. Even after the share markets recovered to pre-GFC levels, these investors had still not
recovered the equity lost during this period.

The credit shortage that was a symptom of the GFC demonstrates the need for all organisations
to take refinancing risk seriously. Similarly, many assumed that market liquidity in the modern
globalised era was a certainty. In fact, many markets saw drastically larger spreads and some
markets were completely closed in the aftermath of the crisis.

It is difficult to pinpoint one clear cause of the GFC. However, the Group of Twenty (G20 2009)
leaders, in their declaration after the summit on financial markets and the world economy,
provided a comprehensive list of root causes:
During a period of strong global growth, growing capital flows, and prolonged stability earlier
this decade, market participants sought higher yields without an adequate appreciation of the
risks and failed to exercise proper due diligence. At the same time, weak underwriting standards,
unsound risk management practices, increasingly complex and opaque financial products,
and consequent excessive leverage combined to create vulnerabilities in the system. Policy-
makers, regulators and supervisors, in some advanced countries, did not adequately appreciate
and address the risks building up in financial markets, keep pace with financial innovation, or take
into account the systemic ramifications of domestic regulatory actions.
Major underlying factors to the current situation were, among others, inconsistent and insufficiently
coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable
global macroeconomic outcomes. These developments, together, contributed to excesses and
ultimately resulted in severe market disruption (G20 2009).

The GFC has also been said to be a telling symptom of massive overconsumption by Western
economies over many decades as a result of cheap and easy credit, with the GFC reflecting the
unsustainability of that overconsumption. To prevent an economic depression, governments and
central banks stepped in by easing monetary policy while increasing government expenditure.
This has resulted in historically low interest rates, as well as governments taking greater leverage
(i.e. debt) onto their own balance sheets.

Volatility in global markets

Figure 1.3 demonstrates the dramatic changes that occurred during the crisis, the unprecedented
volatility of the markets and the unusual state of affairs in current financial markets.
 Study guide | 23

Figure 1.3: AUD exchange rate (1999–2013)

180%

MODULE 1
160%

140%

JPY v AUD
USD v AUD
120%
EUR v AUD

100%

80%
Jan-1999
Sep-1999
May 2000
Jan-2001
Sep-2001
May 2002
Jan-2003
Sep-2003
May 2004
Jan-2005
Sep-2005
May 2006
Jan-2007
Sep-2007
May 2008
Jan-2009
Sep-2009
May 2010
Jan-2011
Sep-2011
May 2012
Jan-2013
Source: Based on data from RBA 2013a, ‘Historical exchange rates’ accessed August 2014,
http://www.rba.gov.au/statistics/tables/index.html#exchange-rates.

Looking at the AUD/USD relationship, between January 1999 and September 2002, the AUD
weakened by 20 per cent. It then almost doubled from these lows until May 2008, fell sharply
during the GFC, but then rose considerably again to be 50 per cent higher than the starting
point. These drastic movements have put severe stress on Australian exporters/importers,
highlighting the importance of sound risk management against currencies fluctuations.

Figure 1.4: Australian Government 10-year bond yields

18.00
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
Aug-1969
Oct-1971
Dec-1973
Feb-1976
Apr-1978
Jun-1980
Aug-1982
Oct-1984
Dec-1986
Feb-1989
Apr-1991
Jun-1993
Aug-1995
Oct-1997
Dec-1999
Feb-2002
Apr-2004
Jun-2006
Aug-2008
Oct-2010
Dec-2012

Source: Based on data from RBA 2013b, ‘Statistical tables’, accessed August 2013,
http://www.rba.gov.au/statistics/tables/#interest_rates.
 24 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

It is useful to look at indices over long time frames. The 10-year bond yield since 1969 (Figure 1.4)
highlights how unusual the current environment is, with central banks throughout the world
reducing interest rates in an attempt to stimulate growth. While the current low interest rates
benefit borrowers at the cost of savers, organisations should be prepared for interest rates to
revert to higher levels in the future.
MODULE 1

Figure 1.5: Commodity price index (1999–2013)

600%

500%

400%
Rural component
300%
Non-rural
200%
Base metal
100% Bulk commodities

0%
Jan-1999
Mar-2000
May-2001
Jul-2002
Sep-2003
Nov-2004
Jan-2006
Mar-2007
May-2008
Jul-2009
Sep-2010
Nov-2011
Jan-2013

Source: Based on data from RBA 2013c, ‘Commodity prices’, accessed August 2013,
http://www.rba.gov.au/statistics/frequency/commodity-prices.html.

Over the last decade, commodity prices have been subject to massive fluctuations, rising over
400 per cent and then falling almost as rapidly (see Figure 1.5). Given the difficulty of predicting
exchange rates or commodity prices, it becomes important to undertake stress testing of
positions to understand the impact on the organisation. It is also important to ensure that there
is a sufficient capital base and liquidity to withstand these shocks and to assess whether there
may be an opportunity for the organisation to benefit from a particular market position.

Debt levels
Global debt levels are at record highs due to unsustainable consumption on credit for the last
two decades, as well as government actions to bail out financial institutions during the GFC
(see Figure 1.6).

Figure 1.6: G10 debt distribution as a percentage of GDP

1000
900
800
700
600
500 Non-financial
400 Financial
300
200 Government
100 Households
0
UK

en

nd

US

Ca ia
da

Z
wa
pa

N
l
ra
ed

na
ro

la
Ja

or

st
er
Eu
Sw

Au
N

itz
Sw

Source: Morgan Stanley Research 2011, ‘FX outlook: The year of the dollar’,
Global Outlook, 28 November, p. 26.
 Study guide | 25

For example, between the years 2007 and 2011, Ireland’s government debt rose from 20 per cent
of GDP to 100 per cent of GDP as a result of the government providing support to its financial
institutions. Just as corporations have credit standards, governments and countries as a whole
have credit standards. While economists generally agree that governments should run a balanced
budget over an economic cycle, they also agree that it is appropriate to take on debt to stimulate

MODULE 1
growth. Economists do not agree on sustainable levels of debts, nor do they agree on the
prognosis for the current debt glut. In reality, measures such as debt to GDP are crude arbitrary
measures. Ultimately, it is the government’s and the country’s ability to repay debts, and investors’
perceptions of their ability to repay, which underpins a country’s sustainable level of debt. It is far
from clear how the current record levels of debt in the western world will play out in the future,
which in itself raises issues of concern.

The European sovereign debt crisis

In 2008 and 2009, European nations exposed to the GFC started showing signs of severe
economic distress as a result of being unable to pay off massive amounts of debt or even roll
over the debt. The crisis that started in 2009 became known as the European sovereign debt
crisis (ESDC). Similar to the GFC, the main precursors of the ESDC were the result of European
governments incurring unsustainable amounts of debt to fund welfare and to support financial
institutions following the GFC.

As the global financial system is seen to be interrelated due to globalisation of the banking
environment in recent years, and as nations started defaulting on their debt repayments,
global financial institutions started to weaken. This was the result of holding weaker European
securities, through direct or indirect participation. Furthermore, many central banks (including the
European Central Bank) came under pressure, with the devaluation of bonds issued by several
European nations, a rise in unemployment in the eurozone and the depreciation of the euro.

Countries in the eurozone such as Greece and Ireland had to accept bailout packages from the
European Central Bank (ECB) and the International Monetary Fund (IMF). However, most of these
bailout funds came with specific conditions to reduce budget deficits (e.g. spending cuts and/
or tax increases), referred to as austerity measures, which contributed to a further decline in the
economic conditions in these countries.

The ESDC raised several concerns for investors. As distinct from the GFC, which was a result of
risky practices by institutional and private banks, the ESDC highlighted the impact of imprudent
government borrowing (most commonly known as ‘sovereign debt’). In the past, government
debt was often seen as a safe haven for investors. However, the issues that began to surface
during the ESDC caused these assumptions to be questioned. The ESDC highlighted the need
for investors in all countries to assess their exposure to sovereign debt as part of their risk
management strategies.

Macroeconomic concerns were also raised as a result of the ESDC. Many economists started to
question the stability of the entire eurozone due to the interdependence of all nations within the
eurozone on the euro and the role of the ECB. Countries such as Germany and France came out
of the GFC in a relatively strong position but were and continue to be heavily exposed to the
ESDC through membership of the European Union. Many analysts have suggested that in order
to boost investor confidence in the eurozone, countries would have to stop using the euro and
revert to using their own currencies. Some analysts have even questioned the role of the ECB and
its impact on the ESDC, and have suggested that countries in the eurozone need to have more
control of their respective national monetary policies to enforce stronger national regulation.

From an FRM perspective, the ESDC has highlighted that governments must manage their
financial risks in a similar way to corporations. If they mismanage their funding and liquidity risks
they will default, causing economic hardship. On a more practical level, corporations must be
wary of sovereign risk and associated exchange risk in the event that the euro is abandoned or
members are expelled from the eurozone.
 26 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Future economic outlook

The ESDC and the GFC have had a knock-on effect on most countries in the Asia–Pacific region.

Countries such as China, India, Malaysia and Indonesia have seen their pre-GFC high-level
growth rates reduce. However, they are still managing to grow at rates that are higher than those
MODULE 1

of affected developed nations. Economic growth rates in these countries have been affected due
to the recent economic environment and decreased demand from trade partners in the US and
the European Union. Furthermore, China has invested several trillion dollars in debt securities of
nations that were affected during the GFC and the ESDC.

At a global level, the last decade has seen an economic power shift from West to East with
the dramatic rise of China and India. This has created an environment of low interest rates
in the West, leading to overconsumption and a build-up of unsustainable amounts of debt.
The debt levels have meant that governments must now choose between austerity measures
to reduce debt or simply printing more money to cover the debts they cannot afford to repay,
risking inflation and debasement of their currencies. As an example, Japan, one of the most
indebted nations in the world, has relaxed its monetary policy to create inflation and lower its
exchange rate. Both approaches potentially have negative economic consequences, with the
result that the Western developed world may suffer a prolonged period of negative real growth.
This precipitous state of global economic affairs highlights the importance that FRM will have
over the next decade.

Implications for global financial markets

1. Regulatory responses
The most immediate reaction to the GFC was a tightening in credit regulations, by both
financial institutions themselves and national monetary authorities.

A second reaction to the crisis was the recommended use of central clearing counterparties
(CCCPs). Using CCCPs for over-the-counter (OTC) derivatives (i.e. private contracts) replaces
the previous hidden exposures between an entity (including corporates, hedge funds and
financial institutions) and financial institutions, which were both less transparent and less
efficient. As an example of the lack of transparency in the current system, a large hedge fund
might have massive OTC positions across the globe effectively hidden from the regulator in
the local jurisdiction. By forcing these transactions through a CCCP and requiring the CCCP
to report to the regulator, the regulator can monitor all positions. Efforts to increase efficiency
in this area have proved to be complex and much remains to be achieved. These changes
are predicted to lead to higher costs of using OTC derivatives and greater liquidity risk for
financial institutions in future.

2. Currency wars
One of the other implications of the stresses on world markets since 2007 has been the
emergence of what is commonly termed ‘currency wars’. Technically, to use the language of
IMF Article IV(1) iii, currency wars occur when countries ‘manipulat[e] exchange rates … to gain
an unfair competitive advantage over other members’ (IMF 2008, p. 6). The US government has
repeatedly raised the issue against China (which was accused of buying market share since 2004
with a substantially undervalued and fixed-rate currency). More recently, the loose monetary
policies of Japan, US and the ECB have in part been suggested as a means to reduce exchange
rates. This could lead to greater volatility in currency markets.

There is great uncertainty in the global economic environment. This carries opportunities for
those who are able to take advantage of the situation, but also carries risks of unstable economic
environments, low interest rates for investors, slow growth due to austerity measures and neutral
or even negative consumer sentiment.
 Study guide | 27

Internal factors
Factors specific to the organisation, include:
• culture;
• mission and objectives;
• policies;

MODULE 1
• risk appetite;
• organisational structure; and
• competitive advantage.

Just as the objectives of organisations differ, the degree of conservatism in the FRM policies is a
product of the risk appetite of the board. The financial risk manager plays a key role in monitoring
and reviewing financial risks and communicating and consulting with the board. The culture of
the organisation will determine how aggressively risks might be embraced. The organisational
structure will dictate the personnel responsible for the different risks. For example, if a treasury
department exists, this will be the functional unit responsible for significant financial risks.

A key internal factor is the risk appetite of the organisation.

Risk appetite
Just as all organisations are different, the qualitative and quantitative risk attributes of each
organisation will be unique. These attributes will be based on the factors affecting the
organisation and its ability to achieve organisational objectives. The risk management process
needs to focus the organisation on those risks which may prevent it achieving its objectives.
Accordingly, there needs to be criteria to judge risks on a consistent basis. Under the standard,
this is done by assessing the likelihood and consequence of risks. All risks can then be considered
in a practical template. This provides the organisation with a consistent understanding of what
risks will be accepted, what risks will be avoided and what risks might be shared or reduced.

Based on Table 1.1, management would focus on managing the most extreme risks, followed by
high, then moderate risks. Minimal action might be taken for low risks.

Table 1.1: Risk rating table

5 Moderate High High Extreme Extreme

Consequence

4 Moderate Moderate High High Extreme

3 Low Moderate Moderate High High

2 Low Low Moderate Moderate High

1 Low Low Low Moderate Moderate

0 1 2 3 4 5

Likelihood

As each organisation is different, so too will be the definition of consequence and likelihood.
Tables 1.2 and 1.3 would be based on the subjective input of key decision-makers with approval
by the board.
 28 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Table 1.2: Consequence

Level Description Severity

1 Insignificant < $10 000

MODULE 1

2 Minor $10 000 to $50 000

3 Moderate $50 000 to $ 200 000

4 Major $200 000 to $500 000

5 Catastrophic > $500 000

For this entity, variations from budget under $10 000 are insignificant based on the assessment of
the board, whereas costs exceeding $500 000 would cause the entity to fail. It follows that greater
attention will be given to risks with the greater consequences. The consequence table is unique
to each entity and its objectives and risk tolerances. While in this entity the catastrophic amount
is based on the quantum that would cause the entity to fail, other boards may set the amount
based on breaching a minimum return on equity.

Table 1.3: Likelihood

Level Description Indicative frequency

1 Rare May occur only in exceptional circumstances

Less than 10% chance

2 Unlikely Could occur at some time

10%–35% chance

3 Possible Might occur at some time

35%–65% chance

4 Likely Will probably occur in most circumstances

65%–90% chance

5 Almost certain Is expected to occur in most circumstances

Greater than 90% chance

Likelihood might be defined as above, or it could be further clarified that ‘Almost certain’ means the
event is likely to occur several times a year, whereas ‘Rare’ might mean once in 50 years. Note that
the risk appetite might also state certain qualitative measures such as a zero tolerance for fraud.

Once the risk appetite of the organisation is determined, it will be possible to plot the various risks
of the organisation in a standard format to assist in assessing which risks are unacceptably high.
 Study guide | 29

Figure 1.7: Risk bubble chart—pre-controls

6

MODULE 1
Un Risk X
4 acc
Consequence

ep Risk Y
tab
ly h Risk Z
3 igh
risk
2

0
1 2 3 4 5
Likelihood

In Figure 1.7, clearly Risk X (at top right) is unacceptably high, based on the board’s risk appetite.
Management would endeavour to manage such a risk through a risk treatment plan.

The risk analysis above is done before implementing controls. It will be repeated after
implementation to test the effectiveness of controls. This two-step approach is important
because it highlights the impact of controls and identifies the controls that are critical to reducing
specific risks—these are the controls on which management should focus in its control activities
(see Module 8 for further discussion).

Assess risk
Identify risk
Risk identification is the process of finding, recognising and describing risks to be managed.
The aim of this first step to create a comprehensive list of risks facing the entity.

It involves identification of the risk and the source of the risk. Later steps involve analysing the
impact of the risk on the organisation, which is followed by evaluating the assessed impact
against the risk criteria (or risk appetite) of the entity. These later two steps assist in determining
the ranking of the risks identified. For all risks considered high or extreme (according to the risk
appetite of the entity), it would be expected that a risk treatment plan would be implemented,
subject to ongoing monitoring and review.

Risk identification can be a very complex task and should not be treated lightly. In most
organisations, key decision-makers will have an excellent understanding of the main financial
risks facing the organisation. The chief financial officer (CFO) particularly should have a detailed
understanding of the business model and its components. The following additional sources
should be used to reinforce the risk identification process.
 30 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Management
Board members and senior managers normally have an excellent understanding of the business
model and the key effects on the business model, including the impact of variables.
MODULE 1

Financial statements and annual report

Under IFRS 7, organisations are required to disclose the financial risks associated with
their financial instruments and the method of managing such risks. Likewise, there is often
commentary in the annual report on the management of financial risks if these are significant.

Business model and use of models generally

The business model of the entity can be a useful source for identifying financial risks. At this
point, it is critical to assess the reliability of the business model. This might be done by:
• back testing the model; or
• comparing recent actual data to the forecasts in the business model.

If the business model is found to be unreliable, this will have a flow-on effect to all of the
financial risks in the entity. The famous quote, ‘If you can’t model it, you can’t manage it!’ is
particularly true of managing foreign exchange risk. For example, if an organisation has highly
probable forecast transaction exposures, it is possible to manage the foreign exchange exposure
with hedging instruments. However, if the forecast foreign exchange exposure is unreliable,
hedging the purported risk would be similar to speculation.

Rating agency reports

Rating agency reports will discuss the various risks in the entity’s business and the future outlook
of those risks. If the entity has a credit rating, that rating will also indicate the key parameters
used in the rating as well as how close the entity is to potentially breaching interest cover,
debt and other key ratios. A change in credit rating may affect the ability of the entity to raise
finance in the future (funding risk) and the interest cost (interest rate risk).

Market analysis reports

For listed stocks, market brokers’ research teams create their own models that identify key
influences on the entity’s current and future results. Such research reports can be useful in
identifying key risk variables.

Risk workshops
An excellent way to develop risk management concepts is to run risk identification workshops
with key personnel. In most instances a workshop will highlight key risks and, after some evaluation
and analysis, the output would be communicated by a risk map, discussed in the ‘Communicate
and consult’ section later in this module.
 Study guide | 31

Example 1.1: Intelligent Systems Ltd

From a risk workshop, the CFO of Intelligent Systems Ltd identified interest rate risk on debt as follows.

Interest rate risk

MODULE 1
Source of risk Current and estimated future debt.

Impact Interest expense and key financial ratios.

Likelihood Almost certain as debt is already contracted.

Consequence Would be based on the current and projected debt levels as well
as the degree of variation possible in interest rates.

The facts collected on this risk include the following data which will continue to be used in the
subsequent steps of the risk identification process.

Debt projected for the Fixed at $10 million

next 3 years

Terms of the debt Interest payments quarterly based on the 3-month BBSW* rate plus 1%

Current BBSW rate 3%

Historical volatility in 1% standard deviation† based on last 6 years

1-year rate

Interest cover ratio Very conservative at current interest rates

(ratio of interest to EBIT)

Notes:
*
BBSW is an abbreviation for the ‘bank bill swap rate’. It is the wholesale interbank rate within
Australia and is published by the Australian Financial Markets Association (AFMA). It is the
borrowing rate among the country’s top market makers, and is widely used as the benchmark
interest rate for loans.
†
See the ‘Glossary of statistical terms’ at the end of this module.

The facts presented in this example will continue to be used to demonstrate the practical workings
of each step of the risk framework.

➤➤Question 1.1
Compare and contrast the risks that would be faced by an Australian newspaper chain and a
wheat exporter.

Analyse risk
The analysis phase is the process of comprehending the nature of the risk and determining
the level of risk. The analysis undertaken will depend on the type of risk. For financial risks,
this will generally involve a quantitative process. For other risks, the analysis may be only partly
quantitative, entirely qualitative or a combination of both.

Continuing Example 1.1 above, we can use the risk facts to determine the expected distribution
of the interest cost over the next year. Figure 1.8 reflects a simulation of results and associated
statistics on the degree of variation in interest rate expense due to changes in the BBSW rate.
One approach might be to do a simulation of 5000 random interest rate movements based on
the volatility of the BBSW rate—this might be achieved by a Monte Carlo simulation.
 32 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Figure 1.8: Histogram of Monte Carlo simulation results

600

500
MODULE 1

Frequency count

400

300

200

100

0
0

1
0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9
0.05

0.15

0.25

0.35

0.45

0.55

0.65

0.75

0.85

0.95
Interest expense $ million

The distribution highlights the possible outcomes over a full year, with the expected frequency
of outcomes on the vertical axis and the computed interest rate expense on the horizontal axis.
An alternative method would be to simply stress test the interest expense by the reasonably
expected variation in interest rates. Based on the risk facts in Example 1.1 and Figure 1.8,
one standard deviation indicates that 68.1 per cent of outcomes will fall within the plus or
minus 1 per cent interest change, and 31.9 per cent will fall outside. Two standard deviations
will cover approximately 97.5 per cent of outcomes (i.e. that outcomes will fall within the plus
or minus 2% interest change). The advantage of statistical analysis is the ease of objective
reporting and assessment of different strategies.

Table 1.4 presents a summarised output of these results.

Table 1.4: General statistics on the distribution

Minimum result $10 000

Lower 25% of results fall below $340 000

Median result $400 000

Upper 25% of results fall above $470 000

Maximum result $730 000

95% confidence levels

• Lower level $210 000

• Upper level $600 000

We can see that the mean interest rate expense is $400 000 (i.e. $10m x 4%, being BBSW of
3% + 1%). Further, 50 per cent of outcomes are projected to fall between $340 000 and $470 000,
while 95% of outcomes are projected to fall between $210 000 and $600 000.
 Study guide | 33

Offsets and embedded contractual agreements

It is important in the analysis of risks that the full impact on the entity is considered. For example,
in the interest rate risk example (Example 1.1), there may be offsetting factors affecting the
interest rate risk of the organisation, such as:
• if the organisation holds property, the tenant lease arrangements might be linked

MODULE 1
to interest rates; or
• if the organisation has operating or finance leases, the lease rate might be linked to
interest rates.

These examples demonstrate the importance of an understanding of any adjustments

in commercial contracts from a risk management perspective. It is also important from
an accounting perspective, and Module 7 looks at the accounting treatment of embedded
derivatives. Reading 1.1 highlights the extent of such adjustments in currency adjustment clauses.

Evaluate risk
Once the risk has been analysed, it is necessary to evaluate it against the established criteria
(or risk appetite) so that it can be ranked to identify management’s risk priorities. To achieve this
end, we now need to translate these results into likelihood and consequence.

Table 1.5: Likelihood

Level Description Indicative frequency

1 Rare May occur only in exceptional circumstances

Less than 10% chance

2 Unlikely Could occur at some time

10%–35% chance

3 Possible Might occur at some time

35%–65% chance

4 Likely Will probably occur in most circumstances

65%–90% chance

5 Almost certain Is expected to occur in most circumstances

Greater than 90% chance

In Example 1.1 we know the debt is committed so the likelihood of interest rate risk is at the
maximum level of ‘almost certain’. However, the likelihood that rates will exceed 1 per cent within
one year is projected to be 16 per cent so the risk would be rated as unlikely. (See Figure 1.19.
The 16% (13.5% + 2.0% + 0.5%) equals the area to the right of one standard deviation.)

Table 1.6: Consequence

Level Description Severity

1 Insignificant < $10 000

2 Minor $10 000 to $50 000

3 Moderate $50 000 to $ 100 000

4 Major $100 000 to $500 000

5 Catastrophic > $500 000

 34 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

As to the consequence, we look at the worst-case scenario. Based on the modelling, this indicates
a maximum interest expense of $780 000, which creates uncertainty of $380 000 from the forecast
mean (i.e. $780 000 – $400 000). In accordance with the consequence table (Table 1.6), this level of
uncertainty would be considered major. Accordingly, this risk would be plotted on our risk table as
shown in Figure 1.9.
MODULE 1

Figure 1.9: Risk bubble chart—pre-controls

6

4
Consequence

Un
acc Interest rate
ep
3 tab
ly h
igh
risk
2

0
1 2 3 4 5
Likelihood

By comparing Figure 1.9 to the risk rating table (Table 1.1), we see that without any controls,
interest rate risk is in the moderate zone of the chart (i.e. likelihood of 2; consequence of 4).
Accordingly, interest rate risk should be considered for further treatment.

Pay-off diagrams
Another way of demonstrating risk sensitivity is to use a pay-off diagram, as illustrated in Figure 1.10.
In this case, costs are mapped to interest rates to determine the sensitivity to rate changes.

Figure 1.10: Cost-based pay-off profile

Gain
–400 000

–300 000

–200 000

–100 000

0 2 4 6 8
Interest rate %

Moderate 100 000

200 000
Major

300 000

400 000
Loss
 Study guide | 35

Figure 1.10 highlights the risk levels with various levels of interest rates using data from Example 1.1.
This associates different interest rates with various trigger points, for example a major risk deviation
requires interest rates to increase form the current 4 per cent to 6 per cent.

An alternative way to show the pay-off is by using a profit-based goal such as return on

MODULE 1
assets (ROA = Net income/Total assets) as the benchmark on the ‘Y’ axis. This is illustrated in
Figure 1.11.

Figure 1.11: Returns-based pay-off profile return on assets (ROA)

ROA %
16.00

14.00

12.00 Bonus level

0 2 4 6 8
10.00 Interest rate %

8.00

Minimum
return 6.00

4.00

2.00

0.00

Clearly, a large number of possible targets can be set. However, once targets have been selected,
they automatically highlight those interest rate levels which are critical to the firm.

➤➤Question 1.2
In each of the following situations comment on the CFO’s opinion and explain what risk analysis
is needed to accurately determine the entity’s risk position.
(a) Transport company
A transport company’s main expense is diesel fuel (a processed product of crude oil with a
current price of USD 100 per barrel) and, accordingly, is considering hedging this risk with a
local bank. However, the CFO has challenged this idea on the basis that there is a fuel levy
in its freight agreements with customers wherein customers pay a freight levy once the USD
oil price per barrel is greater than USD 30.
(b) Service station chain
The major expense of the service station is fuel, which correlates strongly with the USD oil
price and the USD/AUD exchange rate. The purchasing department has proposed locking in
the fuel price for the next six months as forecasts from suppliers indicate that the oil price
will rise significantly in the near term. The CFO has queried this strategy arguing that the
service station has no such exposure.
 36 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

(c) Regulated network (utility) company

Regulated network companies own poles and wire of the electricity grid and typically have
their fees approved by government on a cost plus basis. A network company has $10 billion
in debt. As interest rates are at an all-time low, the accountant has suggested that it might
be opportunistic to lock in rates for the next 10 years. The CFO has queried this strategy on
MODULE 1

the basis that the regulated return for network assets set by the government is based
on resetting interest rates every 5 years at a specific reset date.
(d) Major industrial company
A major industrial company has a $500 million debt, all of which is on a floating (i.e. variable)
interest rate, rather than fixed. The treasurer thinks it is a great time to fix the interest rate
on the debt and is proposing that it be fixed for 10 years. The CFO agrees that interest
rates are generally lower than historical rates but is concerned that 10 years goes beyond
the business model of five years.

Treat risk
Risk treatment is the process of modifying the risk. This might involve taking action or
implementing a control. Some possible strategies include:
• retaining the risk for opportunistic gain;
• removing the source of risk;
• changing the likelihood of the risk;
• changing the consequence of the risk; and
• passing the risk to a third party.

Once the risk is identified and quantified to indicate that the risk is unacceptably high, as
in Example 1.1, it is important that a risk treatment plan is put in place for the risk. The risk
treatment plan will often result in the creation of a board policy on the particular risk with
controls to ensure the board policy is complied with. The practical controls in this respect are
discussed in Module 8.

Retaining the risk for opportunistic gain

In Example 1.1 it is unlikely that the entity will retain the interest rate risk. Such a risk is usually
only retained where an entity has the specialist skill required to manage the risk. Nevertheless,
the ultimate decision depends on the risk appetite of the board and it is possible that it could
retain the full exposure to the interest rates. The board might argue that interest rates are more
likely to fall than rise given the uncertainty in the global economic environment. If full exposure to
interest rate risk is retained, the board might put controls in place that require the treasurer to fix
the interest risk rate on the debt if interest rates rise by a given amount (e.g. 1%).

Removing the source of risk

In Example 1.1, there may be an opportunity to remove the interest rate risk by seeking an equity
injection from stakeholders. This would facilitate a repayment of the debt and hence eliminate
the source of the risk. There may be other alternatives that achieve the same outcome that also
bear consideration.

Changing the likelihood of the risk

The likelihood of the interest rate risk in Example 1.1 is determined by the market volatility of
interest rates. As the organisation has no ability to change the volatility of interest rates, in this
case changing the likelihood is not an option.
 Study guide | 37

Changing the consequence of the risks

The organisation could manage the consequence of the interest rate risk via the use of
derivatives. Interest rate risk management is discussed in greater detail in Module 5. Qualitative
and quantitative analysis would be required to allow the board to assess the risk management
policy that best suits its risk appetite. This decision will be influenced by:

MODULE 1
• costs;
• system ability to handle different instruments;
• preference of the treasurer and senior management;
• accounting treatment;
• views on directions of interest rates;
• preference to retain some upside risk;
• competitor approach;
• ease of explaining the results; and
• current interest rates compared to long-term rates.

An example of the type of quantitative analysis that could be prepared is presented in

Figure 1.12. This figure shows the outcome of 5000 different random interest rate scenarios
and the impact of those hedge strategies on the interest expense. It also indicates the outcomes
without a hedge. At this stage, it is not necessary to understand the different types of hedges
as these will be explained in later modules. This is the type of analysis that could be given to
senior management and the board to aid decision-making.

Figure 1.12: Analysis of different hedge strategies

6001

No hedge
5001
Swap
50% swap
4001 Collar
Frequency

Option

3001

2001

1001

1
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
0.5
0.55
0.6
0.65
0.7
0.75
0.8
0.85
0.9
0.95
1
0

$ million interest expense

There will be positive and negative aspects of each strategy and these should be fully explored
such that the board can make an intelligent decision.

➤➤Question 1.3
Referring to Figure 1.12, outline the advantages and disadvantages of the four hedge strategies
analysed. Explain which strategy you would select.
 38 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Passing the risk to a third party

Organisations frequently pass on to a third party risks that they cannot control. In Example 1.1,
the most common approach is that the organisation would request the provider of the debt to fix
the interest rate on the debt.
MODULE 1

An alternative to this approach might be to pass the interest rate cost through to the customer of
the organisation. The ability to do this will depend on the practices in the industry.

Risk treatment of interest rate risk

The risk treatment plan should be documented for all major risks, and monitored to ensure the
agreed risk treatment plan has in fact been put in place and is operating effectively to address
the risk.

In Example 1.1, after deliberations of the board, and on recommendation from senior
management, an approved risk treatment plan consisted of a treasury policy covering interest
rate risk. The treasury policy, created by senior management and approved by the board,
would set out responsibilities, policy settings, authorised instruments, staff with delegated
authority to execute and approve instruments, controls and reporting.

Risk treatments can create risks

The selected risk treatment can in itself increase risk to the organisation. For example, if derivatives
are to be used to manage risk, the ‘use of derivatives’ in itself needs to be recognised as creating
its own risk. While newspaper headlines periodically report on the major losses from sundry
derivative disasters, there are numerous smaller incidents of misuse that don’t make the news.
Operational risk is covered in Module 8.

Controls
Controls are any action that reduces risk. To be effective, controls must be well designed,
allocated to a responsible person and monitored regularly. The risk treatment process normally
involves the creation of a risk and a control matrix to manage the risk.

Table 1.7: Example 1.1 controls for interest rate risk

Identified risk Control procedure Person responsible Frequency

Interest rate risk Treasury policy on managing interest rate risk is Board secretary As required
approved by the board

The treasury accountant reviews compliance Treasury accountant Monthly

against the guidelines in the treasury policy

A report is sent to the board quarterly setting Treasury accountant Quarterly

out the interest rate risk position

As part of the annual strategic planning Treasurer Annually

process, the interest rate risk management
policy is reviewed and recommendations
for improvement are sent to the board for
authorisation

The control would change the consequence rating of the interest risk from 4 to 1, as there are
now controls to limit the variability of the interest rate expense.
 Study guide | 39

Residual risk
While risk treatment plans will be put in place for major risks, even after the plan is put in place,
residual risk will remain in the organisation. Such residual risk should continue to be monitored
by management and the board. This will keep such risks in the spotlight and focus attention on
maintaining a strong control environment. Further, over time, better techniques may be applied

MODULE 1
to manage the risk as part of a continual improvement process.

In Example 1.1, while a control may be put in place to manage the interest rate risk, there remains
some residual risk. Figure 1.13 repeats the previous pre-controls bubble chart (Figure 1.9) for
interest rate risk.

Figure 1.13: Risk bubble chart—pre-controls

6

4
Consequence

Un
acc Interest rate
ep
3 tab
ly h
igh
risk
2

0
1 2 3 4 5
Likelihood

Figure 1.14 captures the residual risk in the post-controls (see Table 1.7) risk bubble chart.

Figure 1.14: Risk bubble chart—post-controls

6

4
Consequence

Un
acc Interest rate
ep
3 tab
ly h
igh
risk
2

0
1 2 3 4 5
Likelihood
 40 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

➤➤Question 1.4
Explain the difference between the pre-control (Figure 1.13) and post-control (Figure 1.14) risk
bubbles. Underlying data for Figures 1.13 and 1.14 is shown below.
MODULE 1

Pre-controls Post-controls

Risk Likelihood Consequence Risk ranking Likelihood Consequence Risk ranking

Interest rate 2 4 Moderate 2 1 Low

The risk bubble charts are constructed pre- and post-controls as this assists in the understanding
of the most important controls for the board, management, internal audit, and external audit
to focus on. Clearly, in the case of interest rate risk, the control implemented through the risk
treatment plan has been very effective in reducing the interest rate risk to an acceptable level—
provided the control continues to operate effectively. Hence, it is expected that significant
work would be done to monitor the effectiveness of the control and report that it continues to
be effective.

Forecasts
Most commentators have a view on interest rates, commodity prices and exchange rates,
but few consistently predict correctly or maintain audited results of their previous predictions.
Accordingly, any risk treatment plan reliant on a bank’s economic forecast or an individual’s
forecast should be considered with some scepticism.

In Figure 1.15, the range of 12-month forecasts (in relation to AUD/USD exchange rates) is
given for each year. For example, at the start of 1982 (when the AUD/USD rate was 1.12),
the economists forecast an end-of-year rate of between 1.18 and 1.08. In the event, the AUD
finished at 0.98—a full 10 cents below the most pessimistic guess. Even more disturbingly,
the economists’ average guess pointed to an overall strengthening of the AUD, when in fact it
weakened significantly. It was a decade before they got even the direction (up or down) correct.

Figure 1.15: Exchange rate forecast by The Age panel of economists

USD/AUD
1.2 ■ Actual
1.1 ■
Range of forecasts
1.0 ■

0.9 ■
■ ■
0.8 ■ ■
■
0.7 ■ ■
■
0.6
0.5
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Calendar year Financial year

Actual
included
✘ ✘ ✘ ✘ ✔ ✘ ✘ ✘ ✘ ✔
Direction
OK? ✘ ✘ ✘ ✘ ✘ ✘ ✘ ✘ ✘ ✔

Source: Adapted from E. Shann 1987, ‘Forex forecasts too fickle’, Business Review Weekly, 16 October
and compiled from 36 forecasters from banks, business and policy groups and brokers, as appearing
in The Age and The Sydney Morning Herald, various editions, 1988–92.
 Study guide | 41

Communicate and consult

Continuous communication between all levels of management and the board is critical. Likewise,
there needs to be a plan for training new employees as well as employees who have taken on a
risk management role for the first time. In establishing a risk management culture, it is important
that the expectations of all employees regarding their risk management responsibilities are

MODULE 1
clearly communicated. Expectations can be set via induction training, regular professional
development, job descriptions and as part of performance appraisal.

Consultation between the different stakeholders will be necessary throughout the process. It is
important for every employee to identify when uncertainty exists. Better outcomes will always be
achieved by consulting widely on the topic. Consultation might be:
• as part of the risk treatment plan process to choose between different options, such as
agreeing the appropriate hedge approach for interest rate risk;
• with experts in specialised areas to assist with risk treatment plans when appropriate
expertise is not available in house;
• with those in charge of risk management to assist with risk treatment plans, documenting
controls, and allocating responsibility; and/or
• with the board and senior management on whether risks should be incurred—this is
particularly the case when considering new ventures—as extra effort is required to assess
each new risk.

It is vital that all stakeholders are aware of the risk management process and the derived FRM
policies and procedures. The risk map in Figure 1.16 is an excellent way to communicate the risks
of the organisation. Normally a risk map will be created pre-controls then, to highlight the impact
of controls, created again post-controls.

Figure 1.16: Risk map post-controls

High O1 F1 F2
O2 S = strategic
C2 S1 F = financial
O = operational
Consequence

C = compliance
C1 F4
R = reporting
Medium

R1 F3

Low

Low Medium High

Likelihood

Key:
F1 Funding risk
F2 Liquidity risk
F3 Interest rate risk
F4 Counterparty risks
S1 Reputation risk
C1 Compliance with OH&S
C2 Compliance with tax laws
R1 Accurate financial reporting
O1 Management of operating lease agreements
O2 Management of repairs and maintenance
 42 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

A key role of the financial risk manager is not to make all the decisions but to communicate to
the board the financial impact of different strategies in order that the board can determine the
appropriate policies. The financial risk manager can assist the board to set appropriate buffers,
recommend policy and communicate outcomes and results.
MODULE 1

The risk management procedures outlined in this module need to be complemented by the control
processes examined in Module 8. Module 8 is specifically designed to focus on risk controls,
reviews and communications and is therefore supplementary to this module. Together, the two
modules provide a comprehensive overview of the FRM process.

Monitor and review

It is important that the risk management framework is monitored continuously and the
performance of the controls are confirmed as operating effectively. This is usually achieved by
delegating key controls to responsible persons and periodically seeking feedback on those
controls—a process known as self-assessment.

Further, it is important that there is a continuous review of the risks and controls. In large
organisations there should be three lines of defence.
1. The first line of defence involves management and staff at the business unit responsible for
managing the risk and control. The risk may change over time, requiring modifications to the
risk treatment plan. As systems change or markets change, there might be more effective
ways to manage the risk, requiring an update of the risk treatment plan.
2. The second line of defence will vary depending on the organisation. It could be a central risk
group or business control department which would review the initial implementation of the
risk and control plan and would assist as required with later modifications.
3. The third line of defence might be the internal audit department which would audit
compliance with the risk treatment plans.

The board should review and approve the risk management framework and key policies associated
with the framework. The board should have involvement in defining the risks and reviewing key
risk treatment plans. It should receive regular line management reports, internal audit reports and
reports on any breaches. In addition, the board should monitor compliance and be familiar with any
action plans to rectify identified breaches.

Level of sophistication
Risk framework
The size of the organisation and the industry in which the organisation exists will determine the
format of the risk framework. The risk framework needs to be simple and easily understood.
There is always a risk that the framework itself will become so complex and unwieldy that it will
become an administrative burden on the organisation as opposed to a tool by which to drive
value creation.

Risk matrix
There are numerous ways of documenting and circulating risks within an organisation. A standard
approach is to employ a risk matrix that captures all risks and rates the risk pre-controls and
post-controls. The template might also provide a description of key controls in place. It would be
expected that management and the board would have input into the determination of key risks,
the risk treatment plans and continuous monitoring and review. The risk matrix is an easy way to
highlight key risks and is an effective way to review risks as part of strategic planning.
 Study guide | 43

Table 1.8: Sample risk matrix

Risk Rating pre-controls Rating post-controls Key controls

Interest Moderate Low Treasury policy on the control of interest rate risk

MODULE 1
rate risk management; key controls have been delegated
to individuals and subject to ongoing review.

Financial risks
Financial risks refer to any risk that is financial in nature that will prevent the organisation from
achieving its objectives. Unlike many business risks that are unique to different businesses,
financial risks can be defined for all businesses. Nevertheless, the relevance of each financial risk
will depend on the circumstances of each business.

Financial risks defined

Liquidity risk
The risk of not being able to meet financial/funding commitments. This can be due to insufficient
cash, insufficient draw-down facilities (e.g. loans, overdrafts), or the inability to convert assets into
cash quickly without materially moving the price of those assets.

Funding risk
The risk of funding support not being available when required. Funding can be obtained from
borrowing funds from financial institutions or investors. Funding can also be obtained from
issuing shares to investors.

Interest rate risk

The risk of a change in interest rates affecting borrowing costs, interest income and/or
asset/debt values.

Foreign exchange risk

The risk of foreign exchange rate fluctuations impacting revenues, expenses, assets and/or
liabilities. There are three main types of foreign exchange exposures:
1. Transaction exposures resulting from normal operational business activities (e.g. trade purchases
and sales, short-term borrowings) in a currency other than the entity’s functional currency.
2. Translation exposure from the conversion of long-term foreign currency assets (net equity
investments in foreign operations) and liabilities into the entity’s functional currency.
3. Competitive or economic exposures that may be the result (profitable or otherwise) of
adopting a different approach to managing foreign exchange exposures from that taken by
the organisation’s competitors.

Commodity price risk

The risk of a change in the price of a commodity, whether used as an input or generated as
an output.

Credit (counterparty) risk

The risk of another party to a contract not meeting its financial obligations (i.e. defaulting).
 44 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Operational risk
The risk of computer and/or human error or fraud that is generally associated with front,
middle and back office operations in financial institutions and with treasury or related operations
in organisations. These risks are wide ranging and can include errors of omission or commission,
the failure of electronic systems or misunderstandings between financial counterparties.
MODULE 1

Accountants and financial risk

Skilled accountants have always been key players in FRM in any entity. Even in the smallest of
organisations, accountants are typically involved in financial planning, cash flow management,
maintaining financial records, implementing internal controls and explaining variances to budget.
As they progress in their careers, accountants often either become or advise CFOs. A CFO is
primarily responsible for managing the financial risks of the organisation. They are also responsible
for financial planning and record-keeping, as well as financial reporting to higher management.
The CFO supervises the finance unit and is the chief financial spokesperson for the organisation.

The CFO usually reports directly to the chief executive officer (CEO) and directly assists the chief
operating officer (COO) on all strategic and tactical matters as they relate to budget management,
cost benefit analysis, forecasting needs and the securing of new funding. By having a sound
understanding and awareness of general risk management practices and financial risk in particular,
accountants can demonstrate the value that they bring to discussions with the CEO and the board.

The importance of financial risk and the critical role of accountants in managing categories of
financial risk are explained further in Table 1.9. In each scenario, a risk-aware accountant would
have previously reported the relevant risk to the board and ideally would have positioned the
company (via a risk treatment plan). Additional risk management (RM) actions by the risk-aware
accountant are also noted in each scenario.

Table 1.9: Managing financial risk—the role of the accountant

Role of the risk-aware

accountant in understanding
and monitoring compliance with
Scenario Importance of risk category risk treatment plan

1. Liquidity risk The importance of an A treatment plan might include

A highly geared property organisation’s liquidity position not fully drawing the finance
trust holding direct property is reflected in the emphasis on facility, and maintaining an
has fully drawn its funding such cash-oriented ratios as the adequate cash buffer for re-letting
facilities and has no surplus working capital ratio (current vacating leases.
cash. The property value has assets/current liabilities) and
collapsed due to a significant the quick ratio (current assets
economic downturn, and less inventory/current liabilities).
a key tenant goes into It also underlines the importance
liquidation. of maintaining standby funding
facilities as well as cash reserves.
This topic is covered in more
detail in Module 2.

2. Funding risk Most organisations go into A risk aware accountant would

Continuing the example liquidation when they are no longer be familiar with the credit metrics
in Scenario 1. able to raise new funds or breach used by the bank and would
existing funding covenants. Hence, build this into the target financial
an understanding is required on model of the trust, together with
acceptable funding parameters an appropriate buffer to enable
that make an organisation attractive the trust to withstand temporary
to a financier. This topic is covered periods of poor performance.
in Module 2.
 Study guide | 45

Role of the risk-aware

accountant in understanding
and monitoring compliance with
Scenario Importance of risk category risk treatment plan

MODULE 1
3. Interest rate risk Interest rate risk will depend on A risk treatment plan for interest
Assume that the central bank the sensitivity of the entity to rate risk is discussed earlier in the
increases the cash rate by 1% interest rate changes. Hence the module (see Table 1.7). Interest
and your organisation has importance of sensitivity-type rate risk and the management
a floating rate loan pegged tools and techniques. See a list of thereof is covered in Module 5.
to the cash rate. Given the such techniques below.
large debt position of the
organisation this has caused a
significant cash drain.

4. Foreign exchange risk Foreign exchange risk will depend If a foreign exchange is evaluated
The AUD unexpectedly on the sensitivity of the entity to as a high risk for the importer,
falls due to a sudden exchange rate changes. Hence, a risk treatment plan would
decline in Australia’s the importance of sensitivity type include implementing a hedge
balance of payments. tools and techniques. See a list of strategy to achieve the desired
As a result, an Australian such techniques below. outcomes.
importer of clothing from
the US pays more AUD
for the same amount of
clothing. This negatively
affects the importer’s
competitive position for
the current season.

5. Commodity risk Commodity risk will depend on Ideally, when an organisation

Assume that the price of the sensitivity of the entity to retains exposure to significant
iron ore falls as a result commodity prices. Hence the commodity risk, it will have
of a lack of confidence in importance of sensitivity type conservative credit metrics to be
general economic conditions, tools and techniques. See a list able to withstand significant falls
reducing revenues and of such techniques below. in the commodity price. This topic
earnings for an iron ore is covered in more detail in
producer. This causes a Module 6.
breach in a bank covenant
on interest cover (the multiple
of earnings to interest).

6. Credit risk Credit risk will depend on the Credit exposures would be
Assume that a debtor quantum of financial assets on the monitored against pre-approved
declares bankruptcy, resulting balance sheet, the credit quality limits. Limits would be set based
in an uncollected receivable. of counterparties and the extent on credit analysis and the ability of
of any concentration to individual the organisation to withstand the
counterparties. Credit exposure financial loss. This topic is covered
might also arise from financial in more detail in Module 2.
guarantees.

7. Operational risk Significant losses have been Plans might include restricting
Assume that a contract incurred by organisations with derivative trading to systems
note for a currency deal poor internal control over that automatically capture
is not entered into the derivatives. Often the risk cannot all transactions or a similar
organisation’s financial be quantified as the exposures completeness-check control.
system due to human error, created may not be authorised This topic is covered in more
causing a settlement delay or (see Reading 1.1). detail in Module 8.
unmonitored risk of exposure.
 46 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Sensitivity tools and techniques

To analyse and assist in evaluating the financial risks involving sensitivity, one might use many
different tools and diagnostics, including the six discussed below.

1. Sensitivity analysis/stress testing. Very common in financial institutions, where different

MODULE 1

values of an organisation’s key variables will affect a target, such as net profit or return
on equity.

2. Risk maps/pay-off diagrams. Visual tools that display key sensitivities.

3. Scenario analysis. Particularly useful in identifying strategic risks where the situation would
benefit from a series of ‘what-if’ questions. The technique is very useful when testing unlikely
but highly critical events.

4. Gain/loss curves. Another useful tool which helps an organisation to see how a risk can
influence its financial gains or losses. Gain/loss curves do not show correlations between risks,
and they do not show all the risks in the one place.

5. Tornado charts. So named because they rank the variables from top to bottom, from largest
to smallest impact, and thereby tend to resemble the silhouette of a tornado. Similar to
gain/loss curves, tornado charts attempt to capture how much of an impact a risk has on a
particular target such as revenue, net income or earnings per share.

6. Monte Carlo analysis. A decision-making tool that presents large numbers of simulations
under different market conditions to assist in highlighting any outcomes that may not align
with the risk appetite of the board.

Approach models with caution

The calculations needed for FRM have never been easier to perform, given the increased
computational strength of modern computers, which has been a great development for FRM.
This assists in model development, analysis of historical data sets and production of robust
analysis that is easy to understand. It also highlights risks on a consistent basis, removes subjective
bias and simplifies decision-making. Nevertheless, a key finding from the GFC questioned the
over-reliance on models, especially in managing event risk. Models that may work perfectly well in
everyday markets may fail in extreme markets. As a result, often a simple stress test of outcomes
may produce sufficient analysis to aid decision-making without a complicated model.

There is an art to risk management which should never be confused with mathematical accuracy.
The mathematical output may be perfectly correct and still totally meaningless or misleading if it
is based on:
• an unreliable model;
• spreadsheets with significant errors;
• a limited data set of historical numbers; or
• incorrect use.

Unreliable model
We have discussed previously that if the model is unreliable, the output from that model—even if
it is mathematically correct—will be equally unreliable. For example, some of the analysis in this
module uses the ‘normal distribution’ as an assumption. (See the ‘Glossary of statistical terms’ at
the end of this module.) This in itself has been criticised as not capturing the long tails of real life
distributions in a crisis.
 Study guide | 47

Spreadsheet with significant errors

Spreadsheets are a fantastic development in risk management as they allow almost unlimited
flexibility in constructing the desired model to analyse problems. However, for the same reason,
there is an inherent risk that spreadsheets are prone to error. For example, a cell reference might
be changed accidentally or a formula may be incorrect. The potential for errors in a spreadsheet

MODULE 1
are significant and increase with the complexity of the spreadsheet. This can be minimised
by simplifying the architecture, building in checks and reconciliations, and probably most
importantly, applying a common sense assessment of the model’s outputs.

Limited data set of historical numbers

When determining the volatility of an input (e.g. interest rate, foreign exchange rate, commodity
price), it is important to consider the data set being used. There have been times in history when
the various rates have been very stable (e.g. AUD interest rates over 2013). If this data set is the
basis for the numbers, it will give a distorted view of potential future interest rate movements.

Incorrect use
There is a real risk of misinterpreting mathematically produced results. For example, assume
a model states that there is 95 per cent confidence that the maximum interest expense for
the following year is $12 million from a mean of $10 million. The model is not saying what the
maximum interest expense might be. It is stating that, based on the mathematical model,
with the assumed debt levels, assumed normal distribution of interest rates and the limited data
set used in computing the volatility, that $12 million has been computed. Furthermore, there may
be a 0.01 per cent chance that the interest expense will be $14 million. It is a useful exercise
to consider what the worst-case outcome might be in such circumstances by calculating the
worst‑case one-year interest rate change over the full data set of interest rates.

Overlay of common sense

When faced with results from a mathematical model, it is critical to use some common sense
to draw conclusions from the output and consider what additional information might be useful
to make an intelligent decision. Specific thoughts that might be useful include: Do you understand
the model? Is it reliable? What assumptions is the model based on? Could the assumptions be
wrong or misleading? What other information would be useful in decision-making?

Risk appetite in the context of financial risks

Risk appetite is relevant in the determination of every major policy in an organisation. An entity’s
risk appetite is set by the board with input from management. In the context of financial risks,
risk appetite becomes important in the following areas:

General policy
An entity’s risk appetite is evident in:
• the level of uncertainty accepted in business operations;
• the degree of conservatism in organisation policy settings; and
• the level of discretion delegated to different operations.

It is expected that the risk appetite will change with different CEOs and with the composition of
the board. Risk appetite also changes based on external influences. Organisations tend to be
more aggressive in boom times and more conservative in times of decline.
 48 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Hedge strategy
As demonstrated in Figure 1.12, there can be more than one hedge strategy appropriate to
the organisation—based on the core criterion of achieving the organisational objectives within
a defined level of uncertainty. While part of the risk appetite is based on achieving the stated
corporate goals, part becomes subjective; that is, there may be multiple strategies that achieve
MODULE 1

the core objective. As a result, the preferred risk profile will be based on the qualitative and
quantitative advantages and disadvantages of each profile.

Liquidity risk
Risk appetite plays a role in determining the level of cash buffer maintained above normal cash
requirements to fund unexpected cash calls. There is always a trade-off. The greater the cash
buffer, the more protection the organisation has to weather unexpected cash requirements.
However, this buffer is achieved at the opportunity cost of a more expensive working capital
position—the cost of holding excess cash being the difference between the interest earned on
cash and the interest paid on borrowings.

Funding risk
Funding risk is influenced by the capital structure of the entity, specifically the gearing taken
on by the entity. The greater the gearing, the greater the risk. Conversely, based on weighted
average cost of capital (WACC) calculations (see Module 3), often the greater the gearing,
the lower the WACC (as debt typically has a lower cost than equity).

This presents as further trade-off where the optimal level of capital differs from the actual
level of capital by the capital buffer created to protect the entity from one-off unforeseen
events. For example, in protecting itself from an economic downturn, a bank may need to
decide whether to factor in a one-in-twenty-year crisis or a one-in-one-hundred-year crisis.
These decisions depend on the risk appetite of the board, but will also be heavily influenced
by regulators, competitor activity and key shareholders.

Functional currency
A key internal factor in establishing the context of foreign currency risk is the choice of a
functional currency—the currency in which costs and revenues are recorded and in which assets
and liabilities are valued.

International Accounting Standard IAS 21 The Effects of Changes in Foreign Exchange Rates
outlines the concepts of a functional currency and a presentation currency. The standard
defines a functional currency as the currency of the primary economic environment in which
the entity operates and a presentation currency as the currency in which financial reports are
presented. IAS 21 states that when indicators for functional currency are mixed, management
must use its judgment to determine the functional currency that most faithfully represents the
economic effects of the underlying transactions, events and conditions.

Deciding on an organisation’s functional currency is not necessarily an easy task but the
consequences can be profound. Gold-mining companies provide a good example, for the
gold market is clearly dominated by the USD. Investors in gold companies presumably want an
exposure to gold—not to the AUD, which is what they get if everything is hedged into AUDs.
However, if the gold companies choose USD as their functional currency, all AUD expenses,
AUD financial assets and liabilities become foreign currency exposures.

International airline companies compete in an industry also dominated by the USD—fuel,

planes and fares are all fundamentally driven by this currency. The same USD dominates most
metals and grain markets. Under IAS 21 it is necessary to specifically nominate a functional
currency, so the issue is far from academic.
 Study guide | 49

➤➤Question 1.5
Under what circumstances might a company exporting small gold statuettes to Los Angeles avoid
exposure to USD currency risks?

MODULE 1
Example 1.2: Air’s Rock
Air’s Rock, an Australian international air-freight company, has the following mixture of both USD and
AUD exposures over the next four quarters.

Quarter USD exposure AUD exposure

Q1 +USD 10m –AUD 30m

Q2 –USD 5m +AUD 36m

Q3 +USD 5m –AUD 28m

Q4 –USD 10m +AUD 33m

Totals USD nil +AUD 11m

Depending on its choice of functional currency, the air-freight company has either no foreign exchange
exposure or an exposure of AUD 11 million.

• If the company chooses the AUD as its functional currency, it is exposed to the USD. However,
in this example, the USD flows for the year net to nil, except for timing risk, and hence there is
effectively no net foreign exchange exposure at the start of the year (the timing exposure can be
eliminated by using foreign exchange swaps—see Module 6).

• If the company chooses the USD is its functional currency, it is exposed to the AUD. In this example,
ignoring timing issues, the calculated net foreign exchange exposure would be AUD 11 million
for the period.

Treasury function
Larger organisations will manage their key financial risk through a treasury function, which usually
operates as a specialist sub-group reporting to the CFO. Its role might include corporate
finance, FRM and cash management. In the absence of a specialist group, these roles fall to
the finance department. The role and structure of the treasury will vary dependent on the
needs and requirements of the CEO and the board, as well as the type of industry in which the
organisation operates.

Treasury function as profit centre or cost centre

The board needs to specify in advance the key objectives for its business units. These could
include revenue targets, return on assets or equity, financial ratios, such as working capital ratios,
and key indicators relating to the industry—such as number of refugees housed, in the case of an
aid organisation.

It must also specifically resolve whether treasury is to be treated as a profit centre, and therefore
as a business unit, or as a corporate financial intermediary or cost centre. Treasury is essentially
a service centre and should make a major contribution to the organisation either directly,
by managing returns on the firm’s investments and surplus cash balances, or indirectly,
through assistance with contract negotiations. Rarely does it actively seek speculative
exposures. Rather, it manages positions ‘inherited’ from the activities of the business units
and acts as the steward of the organisation’s finances.
 50 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

If a treasury function is to act as a profit centre or a trader (quasi-financial intermediary) it should

also be subject to robust controls similar to those used to manage a trading desk. This would
include daily marking-to-market of open positions and segregation of back, middle and front
office positions (see Module 8). This will be the case in organisations with a trading desk,
an aggressive treasury operation (frequent trading to add profit) as well as a very complex
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treasury operation.

AWA is an example of a company that operated its treasury as a profit centre without satisfactory
controls, which led to disastrous consequences—see Reading 1.1.

Performance measurement in the context of FRM

Within an organisation, in virtually every case, the treasury is a corporate intermediary—a means
to an end rather than an end in itself. The goals of FRM are largely set first by the board and
executives and then by the business units. Benchmarking treasury operations then follow.

Ensuring that correct benchmarks are set for the key areas is one of the primary roles of a board,
as benchmarks always bias behaviour and strongly influence the corporate culture.

An absence of explicit benchmarks will lead to de facto or implicit benchmarks. Benchmarking

follows from the identification of an organisation’s actual and required positions. It cannot be
adequately handled in the abstract, being divorced from the organisation itself.

For example, an organisation with foreign exchange exposures that, even if fully covered,
will only just make adequate returns, would logically adopt a ‘full cover’ benchmark. It need not
spend much time debating the merits of ‘doing nothing’ against ‘covering everything’.

Equally, an organisation operating in an industry where there is a recognised practice of either

covering everything or covering nothing, changes its whole risk–return profile if it moves from
the industry norm. This is usually the case with the prestige car industry, where foreign exchange
variations are routinely passed directly on to the end buyer.

Benchmarking must:
• bias performance towards corporate goals;
• be clear as to whether value has been added; and
• identify both return and risk.

The key to measuring performance lies in the identification of added value (in net present value
terms). The setting of correct benchmarks is one of the most crucial decisions involving treasury
operations. The specific benchmark to be used by an entity critically depends on the level at
which the organisation is contemplating setting its benchmarks. In setting benchmarks it is critical
that such benchmarks do not create negative behaviours in different parts of the organisation.

Figure 1.17: Benchmarking financial risks and corporate goals

Benchmarking

Performance measures

Board – Earnings per share etc.

Business units – Profit margins etc.

– Budgeted returns/costs
Treasury on foreign exchange, debt etc.
 Study guide | 51

Benchmarks according to function

Directors. For directors, there are overarching targets such as share price, earnings per share etc.

Directors also have responsibility for setting benchmarks for the chief executive officer, who in
turn oversees the benchmarking of the business units. It is the board’s appetite for risk that

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influences the targets set.

Business units. The targets for business units are those that reflect areas where the businesses
have both authority and responsibility, such as profit margins or competitive position (market
share and profitability).

Some examples of goals for business units are shown in Table 1.10.

Table 1.10: Strategies for business units (BUs)

Scenario Benchmark/Strategies

Profits are insensitive to movements in foreign exchange, No action required.

interest rates or commodity prices. Benefits and/or costs
will be passed on to other parties.

Foreign exchange, interest rates or commodity prices at Option-like targets, such as protecting
which BUs will experience financial discomfort are well in a minimum commodity price (‘floor’) or
excess of market levels. protecting against rising interest rates (‘cap’).

Foreign exchange, interest rates or commodity prices at Cover everything (i.e. fix the rate).
which BUs will experience financial discomfort are very
close to current market levels.

Industry considerations make any deviation from the status As for competitor (usually either do nothing or
quo a considerable increase in risk. cover everything).

Wish to try to use exposures to increase returns. Set profit targets, but ensure strong systems
and controls are in place and are monitored.

Treasury. The targets for the treasury/finance unit are normally restricted to an overall cost
budget. Speculative targets, such as forecast exchange rates, are totally inappropriate unless
the organisation specifically endorses this high-risk, high-return speculation. If this is the case,
the treasury will be treated as a business unit and appropriate controls and systems must be in
place prior to commencing these operations.

Case Study 1.1: Importance of benchmarks: Exportalot Ltd

For this case study, you should focus on the impact of benchmarks rather than on how the figures are
derived—that is, on the strategic issues rather than the mechanics.

Australian company Exportalot Ltd won a contract involving the export of USD 100 million of goods
denominated in USD.

At the exchange rate of AUD/USD 0.8000 at the beginning of July, revenue would be AUD 125 million
and profits AUD 20 million.

The board decided that it should appoint a treasurer to manage this exposure. When setting the
performance measure, the board’s rationale was:

‘As we have never had a treasurer before, we will benchmark the treasurer’s performance against our
current policy of taking no forward cover.’
 52 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

The treasurer of Exportalot can meet this benchmark by simply never hedging and essentially adopting
a strategy of ‘monitoring carefully’.

However, in this case, the new treasurer believed that the USD would fall over the year. Given the bias
introduced by the benchmark of ‘doing nothing’, to take out a large percentage of forward cover would
MODULE 1

be extremely personally risky, so only 20 per cent cover was taken, and 80 per cent was left unhedged.

In fact, the USD did fall (therefore, the AUD rose)—the treasurer guessed correctly. While 20 per cent
was covered, the remaining 80 per cent was sold at exchange rates that resulted in cutting profit by
AUD 10 million or by 50 per cent. Yet against the benchmark of ‘do nothing’ or zero cover, the treasurer
had done extremely well, beating that benchmark by several million on the USD 20 million sold forward
and was awarded a bonus as money was made on the USD 20 million that was hedged.

An even more bizarre consequence of using this inappropriate benchmark is that had the treasurer
guessed incorrectly against the ‘do nothing’ benchmark, the hedge program would have lost money.
The treasurer may also have lost his job, although the company itself would have exceeded its
budgeted profit levels because of the increasing value of the remaining unhedged 80 per cent of its
export revenues.

The main purpose of this example is to highlight the critical importance of setting the benchmark itself.

If a ‘do nothing’ benchmark is used, the treasurer will hit budget if nothing is done. So the treasurer
will ‘monitor carefully’ which, in effect, is precisely the same thing as doing nothing.

Should the benchmark be to fully cover at currently available rates, the only way to ensure that the
budget rate is achieved is to cover everything immediately the board’s decision is taken.

It is important to note that full cover is not the same as taking no risks, for commercial risks may remain.
Full cover not only removes all downside risk, but also removes upside risk, or the opportunity to
benefit from favourable movements in interest rates, commodity prices or currency rates. Therefore,
a firm can lose market share if it fixes its revenue while its competitors remain exposed to favourable
movements in the interest rates, commodity prices or currency rates. Industry practice is therefore an
important consideration for directors when determining their hedging policy.

Conclusion
Directors need to put the benchmarks in place only after they have established the context of the
business and identified, analysed and evaluated risks. Only then can sensible benchmarking take place.

Financial risk in different industry sectors

Parallel universes: Bank and corporate treasury operations
Risk management must be tailored to the circumstances of each entity. A clear demonstration
of this fact arises when considering a ‘bank’ and ‘corporate’ organisations. It is no exaggeration
to say that virtually the only thing that banks and corporates have in common is the buying and
selling of financial instruments and products. Additionally, the only other thing that a corporate
treasury function has in common with a bank treasury is the word ‘treasury’. It is essential to
understand that the two operations are deliberately designed to provide very different services
as they are charged with significantly different tasks.

Table 1.11 lists 10 key differences between corporates and banks with respect to their treasury
functions.
 Study guide | 53

Table 1.11: Differences between bank and corporate treasury functions

Function Bank Corporate

1. Portfolio of commodity, No natural exposure Natural exposures; mining,

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currency and interest rate agriculture etc.
exposures

2. Financial risk The whole business is financial Major financial risks are a
risk management by‑product of the commercial
operation

3. Regulation Highly regulated Minimal regulation

4. Managing embedded risk Sources of financial risk tend to Commercial agreements

be more transparent frequently have hidden financial
risks in the form of embedded
derivatives

5. Cash flow or mark to market Often focused on market value Most corporates focus on
cash flow

6. End-user: Financial products Intermediary: price maker Customer: price taker

only a means to an end

7. Status of treasury Treasuries are essential Treasury is not essential

8. Profit or cost centres Treasuries are profit centres Treasuries are usually cost centres

9. Use of market price forecasts Issues financial market forecasts Consumer of financial forecasts
but does not use them from banks

10. Status of outright prices Spreads or margins are the key The outright price (i.e. actual
to pricing quote) is the key to pricing

Each of the 10 key differences is explained here in more detail.

1. Portfolio of exposures. Companies start with a commodity exposure, such as coal in the
case of a mining company or software in the case of an IT company. Their key exposure
is to their commodity price, that is, coal or software. Their foreign exchange exposure is
either direct, as in both these cases, or indirect, where an organisation may become more
competitive or less competitive simply because an exchange rate movement has changed its
price effectiveness in global markets. For example, when the Australian dollar appreciates,
many domestic manufacturers lose market share as imports gain a price advantage purely
due to this movement in exchange rates, rather than any change in relative productivity.
Put simply:

Costs / Revenue = Price (commodity) × Price (currency) × Quantity.

In addition, organisations can have quite different time horizons, from a few months in the
case of importers who can vary their source of supply to decades for commodity exporters.
 54 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

2. Financial risk. The core risks for commercial organisations are commercial risks, with financial
risks arising from these core business risks as a by-product. For example, a sugar producer
would be expected to have excellent skills in managing the growing, harvesting and marketing
of sugar but may be less equipped to manage interest rate, currency or commodity price
risk. Retailers tend to have skills in marketing and inventory management but rely on financial
MODULE 1

institutions to assist in liquidity and working capital management. They use financial products
rather than create them and manage the residual risks of a portfolio via financial instruments.

Financial institutions have an entirely different opening position. As a result of being highly
regulated, they hold very limited open positions and what exposures they have are ‘pure’
in the sense that they are not tied to commodity prices such as sugar or wheat. Their major
financial risk is counterparty risk reflecting their role as a financial intermediary.

3. Regulation. As financial institutions play a critical role as intermediaries in the economy they
are highly regulated. APRA regulates banks via prudential standards that cover: lending
practices and limits; capital and reserve requirements; governance practices; disclosure
requirements; and restrictions on activities. Banks are subject to ongoing APRA reviews to
ensure standards are met.

4. Managing embedded risk. Fewer than 10 per cent of Australian-based organisations

purchase over-the-counter (OTC) or the alternative exchange-traded options and other
derivatives from financial institutions. However, the proportion of Australian organisations
with ‘live’ option positions (embedded derivatives) rises to over 80 per cent when contract
or commercially based options are added. These options are called ‘embedded options’
(or embedded derivatives in accounting terminology) and are in the form of pricing clauses,
re-pricing clauses, warranties, ceiling/floor pricing agreements, currency-related price-
adjustment clauses and so on. (There are also ‘real’ options that need to be considered,
and these are discussed in Module 4.)

All financial instruments can be replicated in commercial contracts—for example, a price

revaluation clause could have the same effect as a forward currency contract. Normally one is
superior to the other and treasury is in a position to determine which is preferred.

Identifying and valuing these commercially sourced options (embedded derivatives) as well
as the financial market–sourced options or negotiating at the pre-signing stage for options to
be included as pricing conditions (embedded) is a crucial role—and mandatory under IAS 39
Financial Instruments: Recognition and Measurement if the commercial contract is viewed as
a host contract (covered in Module 7).

As these have exactly the same effect on the commercial outcome of an organisation’s
activities as options and derivatives purchased from financial institutions, they need to
be identified, quantified and continuously managed. Often they are cheaper than those
available from financial institutions, which is why it is crucial to get advice when negotiating
contracts. Many organisations do not properly identify or price these embedded options,
which may lead them to make serious errors in the management of their financial risks.

Reading 1.1 details a case study involving AWA Ltd, which actively traded an exposure to foreign
exchange that it never had. The company’s exposure was at least 50 per cent neutralised by
embedded options in the form of a guarantee by the government to reimburse losses from
currency volatility. You should refer to Reading 1.1 now.
 Study guide | 55

5. Cash flow dominates over mark-to-market valuation. Mark-to-market valuation refers to

the requirement under International Financial Reporting Standards (IFRSs) and the Australian
Accounting Standards Board (AASB) that securities valuations reflect current pricing based on
market prices. Trading desks in financial institutions usually mark-to-market their position to
determine profitability.

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Non-financial organisations are far more focused on cash flows, as debt servicing requires
cash payments, and a single default can result in breaches of covenants, the calling-in of
loans and even administration or receivership.

6. End user of financial products. Organisations are price-takers, not price-makers, and the
best way for them to properly price financial instruments is to always get at least two quotes
(theoretical prices are purely academic). Banks make money by buying and selling financial
products, and if they can get a larger margin it is logical for them to price accordingly.

7. Status of treasury. Every organisation has treasury-related activities but over 80 per cent
do not have a formal treasury function. All banks and most other financial institutions have
treasuries as it is their trading interface with clients.

8. Profit or cost centres. Corporate treasuries may generate profits but this is rarely a core
role as it is highly likely to put treasuries into conflict with the business units and their role as
financial advisors. On the other hand, banks are actively operating as profit centres as they
are a core business unit.

9. Use of market price forecasts. Financial institutions make money by trading. They promote
trade by providing estimates of price movements. However, financial institutions are far more
interested in the margins between buying and selling than outright levels (i.e. actual prices).
They want volatility and activity. Organisations are almost precisely the opposite—they want
certainty and stability and often make more profit from not trading financial instruments
(or using commercial contract clauses instead).

10. Status of outright prices versus margins as the key to profitability. Point (5) above
relates to the statement of financial position and statement of comprehensive income,
while this point focuses more on trading business. Take foreign exchange as an example:
banks make most of their profit from margins, or the difference between buying and selling
rates—they do relatively little proprietary trading or speculating. As a result, they are largely
indifferent to the Australian dollar trading around parity or at half that value. Corporate
organisations are concerned about the outright levels and are relatively unconcerned about
the spread or margin between buying and selling rates.

The corporate treasury function is strategically important to all organisations because of its
role in the identification and management of financial exposures and the funding of corporate
operations. It is much wider in scope than a financial institution’s treasury operations and has the
potential to add considerably to the overall stability and value of the organisation.

➤➤Question 1.6
Refer to Reading 1.1 on AWA and answer the following questions:
(a) What were the apparent danger signs prior to the final close-out?
(b) What are six key questions directors must ask that may help them avoid a repetition of
this case?
(c) Suggest a strategic approach to foreign exchange management for AWA.
 56 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

The framework for FRM

Identifying financial risk and opportunity in an organisation
In a financial sense, risk is viewed as the chance of variation or volatility in value.
MODULE 1

To re-emphasise an earlier and important point, risk can be good or bad—and boards and CEOs
require their risk managers to increase profits from favourable movements in revenues or costs
related to financial exposures while adequately controlling unfavourable movements in the same.

The key to risk management is to trade off risk and return, not simply to eliminate exposures
to commodity and financial markets. Furthermore, this trade-off should be understood and
approved by the board.

Each financial decision involves this trade-off between risk and return. For example, an investment
in a short-term government financial instrument is considered risk free because there is little chance
that the investor will not receive the stated return if the instrument is held to maturity. Alternatively,
an investment in the shares of a company gives rise to a range of possible returns (both negative
and positive) and is therefore treated as a more volatile (riskier) investment.

Risk management is about enhancing opportunities and limiting or eliminating threats. Such
management involves the financial risk manager seeking solutions in both the commercial sector,
for primary risk management through contract and commercial negotiation, and in the finance
sector for secondary risk management through the use of the spectrum of financial markets and
instruments.

It is worth noting that once it has been identified and quantified, virtually any financial risk can
be managed—at a price. The reason that this module does not require memorising a large list
of various financial instruments is because the exercise misses the point. Virtually any risk can
be adjusted or eliminated over a wide range of timeframes and in a great range of currencies,
using either commercial markets (largely through contracts) or financial instruments and markets.

If a financial risk manager can identify both the initial position and the required goal, the solution
or solutions are achievable—but whether they are actually implemented will largely depend on
the cost-benefit analysis.

The benefits of lower risk are provided by those who finance the business (i.e. shareholders and
financiers) in the following ways:
• Higher share price. Lower volatility in profit and/or the balance sheet should lead to a more
stable share price, and many shareholders are willing to pay a premium for a more stable
share price.
• Cheaper debt. Less risk to financiers should also translate to a lower cost of debt (although
this may be negated if the gearing level is increased).

A key role of the financial risk manager is not to make all the decisions but to communicate to
the board the financial impact of different strategies in order that the board can determine the
appropriate policies.
 Study guide | 57

Figure 1.18 builds on the FRM framework developed earlier in the module and summarises
the various aspects of a typical FRM process, with each of the five steps expanded to illustrate
the types of risks or the risk management procedures involved in each step. For example,
under the heading ‘Determine the risk factors’, seven different areas are listed for investigation.
These are not intended to be an exhaustive list, and individual businesses and organisations

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will have other more specialised risks, such as sovereign risk in the case of overseas operations
susceptible to being nationalised, or environmental risk in the case of extractive industries
(e.g. forestry and mining).

Figure 1.18: Specific financial risk management process

Establishing the context

1. Set the core criteria

Stakeholder Functional Business/Industry Key strategic

expectations currency drivers objectives

Apparent exposures

Risk identification
2. Identify exposures

Internal Embedded Timing Commercial

offsets options mismatches adjustments

Actual exposures
Risk analysis
3. Determine the risk factors

Interest Commodity
Liquidity Funding FX Credit Operating
rates price

Risk-adjusted exposures

Risk evaluation
4. Appraise risks

Probabilities/
Tolerances Contingencies Project
Consequences

Benchmarked exposures
Risk treatment 5. Manage risks
(treasury operations)

Money
FX Capital Equity Derivative Investment Hybrid
market

Ongoing communication, review and consultation

 58 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Case Study 1.2: Northern Rock

Northern Rock PLC, the eighth-largest British bank by capitalisation, was listed on the London Stock
Exchange in 1997 and a decade later had the distinction of being the first UK bank since 1866 to
collapse as a result of a credit squeeze and a run on the bank by its depositors. It was nationalised
the following year before being sold back into the private sector in 2010.
MODULE 1

The bank was a direct casualty of the 2007 global credit crisis and a prime example of how the actions
of the banks’ providers of credit, not so much the loss of confidence of depositors, led to its demise.

Northern Rock started as a building society, but once it became a public company it borrowed
extensively from British and international capital markets, particularly through securitising its mortgages
and on-selling them to the financial markets. Northern Rock was highly leveraged and particularly
vulnerable to any reduction in the availability of credit from these markets, more so as it had a largely
short-term portfolio of borrowings. When it collapsed in September 2007 its deposit base was only
23 per cent of its total borrowings—the lowest of all the major British banks.

During the 10 years of its life as a listed company, Northern Rock had an average annual growth in total
assets in excess of 20 per cent per annum, growing from around GBP 17 billion to GBP 114 billion.
Its Annual Report and Accounts 2006 (p. 41) gives a flavour of the way growth was financed:
During the year, we raised £3.2 billion medium term wholesale funds from a variety of global
sources, with specific emphasis on the US, Europe, Asia and Australia. This included two
transactions sold to domestic US investors totalling US$3.5 billion. In January 2007, we raised
a further US$2.0 billion under our US MTN [medium term notes] programme.
Key developments during 2006 included the establishment of an Australian debt programme,
raising A$1.2 billion from our inaugural issue. This transaction was the largest debut deal in
that market for a single A rated financial institution targeted at both domestic Australian
investors and the Far East.

This annual report conveys very well the atmosphere of growth and the ready availability of credit.
Northern Rock was highly vulnerable to the GFC because it had long-term assets financed by short-term
loans. This timing mismatch was public knowledge and was also being experienced by the financiers
themselves. Thus there was a precipitous decline in the availability of refinancing facilities as well
as a sharp increase in funding costs. When the de-leveraging of the credit markets was triggered in
August 2007, Northern Rock’s previously extensive sources of short-term funding evaporated. It sought
protection from the Bank of England in mid-September, triggering a depositors’ run on the bank, which
further exacerbated the liquidity crisis and, within months, the forced nationalisation of Northern Rock.

Among the many implications for borrowers and lenders, four stand out—and all relate to the statement
of financial position:
1. Over-leveraging can be fatal because, if there is a crisis, the reduction in the amount and
affordability of funds can be both swift and severe (refinancing risk).
2. Timing mismatches between borrowing and lending can in themselves lead to untenable
constraints on working capital (liquidity risk).
3. A growth strategy must be accompanied by a defensive strategy that is in place and able to be
triggered if needed. If the growth plan is not defensible, it needs revising. Given the fallout from
the GFC, organisations need to anticipate the emergence of further crises.
4. A refinancing strategy is as crucial as the original financing plan.

In a global financial environment, no economy is insulated against fallout from one of the world’s
largest economies.
 Study guide | 59

Case Study 1.3: Bright Gold Corporation—Part 1

This case study illustrates how to apply FRM concepts in practice. (Part 2 of the Bright Gold case study
can be found in Module 8.)

Bright Gold Corporation has hired you to act as its CFO.

MODULE 1
Basic company details:
• This Australian company is well established, with gold mines in Western Australia and South Australia.
• The Western Australian mine is its main producer and produces around 200 000 ounces a year.
The South Australian mine produces around 50 000 ounces. Both have a mine life of three years.
The mines are mature and accordingly production rates are very stable, with 95 per cent confidence
that there will only be a 5 per cent variation from forecast.
• The cost of producing the gold is about AUD 800 per ounce (= USD 640 per ounce at an exchange
rate of AUD/USD 0.8000).
• At the current selling price for gold of AUD 1000 per ounce (USD 800 at the spot rate of
AUD/USD 0.8000), the profit margin above production costs is 25 per cent. The budgeted target
is a 15 per cent profit margin above costs. The board of Bright Gold has resolved that any return
below this is unacceptable and must be avoided. It also does not wish to use complex derivative
products to hedge the risk but is open to the use of straight forwards (which lock in a price on a
future date).
• The company has a three-year floating-rate loan of AUD 50 million at BBSW plus 2 per cent. The
current all-up rate is 6 per cent.
• The annual standard deviation of gold prices over four years has been AUD 184 per ounce and
annual standard deviation for interest rates is 1 per cent.

Projected profit

Year 1 Year 2 Year 3

$m $m $m

Gold revenue 250 250 250

Cost of production 200 200 200

Gross profit 50 50 50

Overheads 10 10 10

Interest 3 3 3

Depreciation 7.4 7.4 7.4

Net profit 29.6 29.6 29.6

Risk process
A summary of the framework of the analysis is shown in the following table.

FRM framework

Stage Task Outcome

1 Consider internal and external factors Understand the market and company objectives

2 Identify risks Clear identification

3&4 Analyse and evaluate risks Transparent assessment

5 Risk treatment plan Set strategy and policy

6 Monitoring and review Report against benchmark

 60 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Step 1: Consider internal and external factors

First, what is the functional currency? If the answer is the USD, the company is exposed to ‘foreign’
currency exposures to the AUD. If the answer is the AUD, the USD becomes the foreign currency for
management and reporting purposes.
MODULE 1

Choosing the functional currency is a crucial decision and, with Australian gold companies, a strong
case can be argued for both the USD and the AUD. In this case, the board of Bright Gold Corporation
has resolved that its functional currency will be the AUD. At the same time, there must be prudent
management of the cash resources to prevent insolvency and to ensure that Bright Gold has the ability
to raise finance when required.

The company must also determine its business targets, such as return on equity or simply net profit.
In this case the board has opted for the latter measure because it is unambiguous and easily tracked
by the business units (the Western Australia and South Australia mines).

Having resolved that the functional currency is the AUD, the following financial information can be
provided as part of the next phases of the risk management process.

Gold market financial prices

Market Spot 1 year 2 years 3 years

USD/AUD 0.8000

Spot gold rate AUD 1000

Outright gold forward AUD 1140 AUD 1225 AUD 1315

Internal risk likelihood and consequence tables have been constructed using the board’s stated risk
appetite as a guide.

Likelihood

Level Description Indicative frequency

1 Rare May occur only in exceptional circumstances

Less than 10% chance

2 Unlikely Could occur at some time

10%–35% chance

3 Possible Might occur at some time

35%–65% chance

4 Likely Will probably occur in most circumstances

65%–90% chance

5 Almost certain Is expected to occur in most circumstances

Greater than 90% chance

Consequence

Level Description Severity

1 Insignificant < $1m

2 Minor $1m to $5m

3 Moderate $5m to $10m

4 Major $10m to $20

5 Catastrophic > $20m

 Study guide | 61

The likelihood table is the same as that previously used. The consequence table has been modified
to reflect the risk appetite of the board. Specifically, the board is seeking at least a 15 per cent margin
above production costs. At the current gold spot price of $1000, there is a $20 million difference
between the current 25 per cent margin above production costs and the minimum 15 per cent, hence a
drop of $20 million would be seen as catastrophic.

MODULE 1
Step 2: Identify financial risks
It is critical to ensure that all financial risks have been identified and properly quantified. Also any offsets
should be identified. Key financial risks include: USD gold risk, foreign exchange risk, funding risk,
liquidity risk, and operational risk.

No other internal offsets or embedded options were identified or were able to be negotiated.

Steps 3 and 4: Analyse and evaluate risks

Liquidity risks
Bright Gold has obligations for floating debt. To determine the liquidity risk, a cash flow statement
needs to be prepared together with an estimate of an appropriate cash buffer determined by analysis
of possible scenarios (e.g. the mine is shut by a strike, flood, tunnel collapse). For brevity, in this case
study, we assume this risk to be moderate.

Commodity price exposures

Bright Gold’s exposure to the highly volatile gold price is 250 000 ounces of gold per annum for three
years, currently priced in USDs and also exposed to the volatile AUD/USD exchange rate. In addition,
Bright Gold has exposure to production risk.

Currency price exposures

Bright Gold’s functional currency is the AUD, so the company is exposed to the USD as international
markets price and pay for gold in USD, not AUD. As Bright Gold will need to convert the USD received
back into AUD, the company will benefit from a stronger USD, but will suffer when the USD weakens.

Credit risk
Bright Gold has no credit exposure to its customers as terms are cash on delivery.

Funding risk
As Bright Gold has $50 million in interest-bearing debt and therefore requires continuing access
to external funding, understanding the banks’ key requirements for liquidity ratios and cash flow
predictability will be important.

Operating risk
In the context of financial risk, the operating risks could relate to the systems used to capture and
monitor exposures, input errors, system breakdowns and fraud.

Risk-adjusted exposures are now calculated as follows.

A 15 per cent margin above production costs requires a minimum revenue of AUD 920 per ounce
(i.e. AUD 800 × (1 + 15%)).

Foreign exchange
If the Australian dollar rises (USD falls), the AUD value of the gold will fall. Bright Gold estimates that it will
receive AUD 1000 per ounce at an exchange rate of AUD/USD 0.8000. Regardless of the exchange rate at
the time of sale, Bright Gold will receive USD 800 per ounce for the gold as it is sold on an international
market. If the AUD rises to AUD/USD 0.9000, when Bright Gold converts USD 800 per ounce back into
AUD it will yield only AUD 888.89 per ounce (i.e. USD 800 / 0.9000), not AUD 1000 per ounce as originally
budgeted—a reduction of AUD 111.11 per ounce. (From a US perspective USD 1.00 = AUD 1.11 when
previously USD 1.00 = AUD 1.25.)

The margin above cost of production was 25 per cent, (AUD 1000 – AUD 800)/AUD 800. This now falls to
11 per cent, (AUD 888.89 – AUD 800)/AUD 800, which is below the budget rate of 15 per cent.
 62 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Keeping the gold price constant at USD 800, the break-even exchange rate to achieve the target is
AUD/USD 0.8696 (i.e. USD 800 / AUD 920). This means that a rise of 7 cents (from 0.8000 to 0.8700) in
the exchange rate would breach the target margin.

Gold price
MODULE 1

If the gold price falls from USD 800 to USD 700 (at AUD/USD 0.8000), the AUD value of gold falls
from AUD 1000 per ounce to AUD 875 per ounce (i.e. USD 700 / 0.8000). The margin above cost of
production falls from 25 per cent to 9 per cent (i.e. (AUD 875 – AUD 800) / AUD 800), which is below
the budget rate of 15 per cent.

Keeping the exchange rate constant at AUD/USD 0.8000, the break-even gold price to achieve the
target is USD 736 per ounce (i.e. AUD 920 × 0.8000). This means that a fall of USD 65 per ounce
(from USD 800 to USD 735) in the exchange rate would breach the target margin.

Interest rates
With AUD 50 million of variable rate debt and a margin above production costs of AUD 200 per ounce,
Bright Gold is not significantly directly affected by interest rate changes. That is, a full 1 per cent
increase in the BBSW would only lead to a AUD 0.5 million increase in interest expense.

Summary of key exposures using simple stress tests

Foreign exchange Interest rates Commodity prices

Effect on benchmark of a Foreign exchange up Not significant Gold down

major change in currency 10 cents to AUD/USD USD 100 to USD 700
rates/prices 0.9000 cuts margin cuts margin over
over production costs production costs
to 11% (from 25%) to 9% (from 25%)

Movement required for 7 cents Not applicable USD 65 per ounce

margin to fall below target

Volatility or risk High Low High

Risk category Unacceptable Acceptable Unacceptable

Statistical analysis
The Tornado chart below shows, with 95 per cent confidence, the effect of key inputs into the business
model. It confirms the analysis above that the AUD gold price (capturing both gold and foreign
exchange risks) is the major influence on results—floating interest rates have almost no impact and
the production variability has an impact but it is not considered significant.

Tornado chart of risk—95 per cent confidence of forecast profit outcome

AUD million
–100 –50 0 29.6 50 100 150

AUD gold price –76 +76

Low
High
Production –12.5 +12.5

Interest rate –1 +1
 Study guide | 63

The mid-line (AUD 29.6 million) represents the current projected net profit from the projected profit table
at the start of this case study. The Tornado chart shows the degree of variation in profit expected based
on two standard deviations and the assumption of a normal distribution of outcomes (see ‘Glossary
of statistical terms’ at the end of this module). The visual presentation makes the tornado chart an
excellent way of highlighting the key determinants of profit.

MODULE 1
Risk bubble chart—pre-controls
6

4 Un
Consequence

acc
ep Gold
tab
3 ly h
igh Production
risk
2 Interest
Refinance risk
1 Liquidity risk

0
1 2 3 4 5 6
Likelihood

Overall, gold risk (combining foreign currency and USD gold price) and refinance risk are unacceptably
high risks. Production and liquidity risks are moderate. Interest rate risk is low and insignificant.

Step 5: Risk treatment plan

Gold and currency
Normally, a comprehensive analysis of the various risks would be conducted by a scenario analysis.
The impact on shareholder value, cash flows and profitability of, say, the gold price increasing or
decreasing would be evaluated. Hence, the shareholder value model would be stress tested for various
market scenarios so that critical risks and their importance can be assessed.

Three main alternatives are available to Bright Gold with respect to gold price and currency exposures
(which will be managed together in this case, but could also be managed separately).

1. Do nothing
This is acceptable if the stakeholders agree that they want a straight exposure to gold—which
they can hedge through use of their own portfolios. However, this would have to be clearly
communicated in advance to all shareholders, employees, bankers, other suppliers and other
stakeholders as it is a highly risky strategy and may result in high levels of profit or serious losses.
Often, a ‘do nothing’ strategy is unacceptable to financial lenders given that Bright Gold has
borrowings. Furthermore, we are told that the stakeholders of the company wish to achieve a
minimum 15 per cent margin over production costs so a do nothing approach is not consistent
with this objective.

2. Cover everything
At present forward prices, gold could be sold into AUDs for an average of around AUD 1227
(depending on timings—but for current strategy-setting purposes, this figure is sufficiently
accurate).

This would result in a margin above costs of 53 per cent (i.e. (1227 – 800) / 800), well above the
budget rate of 15 per cent. This would be acceptable to some stakeholders (such as the banks,
which do not benefit from excess profits or dividends), but means that the company would not
benefit from further rises in gold prices.
 64 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

3. Selective hedging
There are many alternatives under this heading and it could also be titled ‘financial engineering’.
Module 4 ‘Derivatives’ goes into considerable depth in this area. For example, only a proportion of
expected gold production and/or currency risk could be hedged, such as 90 per cent in year one,
80 per cent in year two and 70 per cent in year three. The variations are limitless and careful modelling
MODULE 1

can lead to a result that fits the objectives and risk appetite of key stakeholders.

There is no single correct answer except in hindsight, which is useless for planning purposes.
Further, once any decision has been taken, it needs to be monitored with changing circumstances
communicated to the stakeholders.

Step 6: Monitor and review (treasury operations)

The Bright Gold case study continues in Module 8, where monitoring, measurement and ongoing
communications are discussed in detail.

➤➤Question 1.7
How should a gold company determine whether to hedge its USD exposures?

➤➤Question 1.8
An Australian wheat producer sells wheat to the Middle East in AUD. The price that the producer
receives depends on the global price for wheat. Which one of the following financial risks does
the producer have?
(a) No risk, as the producer will receive Australian dollars.
(b) Commodity risk only, as the producer will receive more for the wheat if the global wheat
price rises and payment is made in Australian dollars.
(c) Liquidity risk, if a client does not pay on time.
(d) Commodity, liquidity and foreign exchange risk, as the price the producer receives is
dependent on the world price, which is quoted in USD.
 Study guide | 65

Review
FRM is a crucial part of any organisation’s operations and is a continuous process rather than a
one-off or annual exercise. In the current economic environment, never has there been a more
compelling case for strong risk management practices. Accountants and CFOs are well-suited by

MODULE 1
their skill sets and positions to add significant value to organisations in this area, as well as to the
more traditional accounting roles in finance.

This module has provided a principles-based standard methodology for risk management that
could be applied to any risk and is certainly effective for financial risk. Tools have been provided
to graphically assess risks pre- and post-controls, and to help determine the likelihood and
consequence of risks. Approaches to managing high risks down to a more acceptable level have
been suggested.

The module also explained the consultation and communication process as well as the regular
monitoring and communication of exposures. Management of these areas is crucial if FRM is to
be successfully implemented. Module 8 considers the controlling of risks in more depth.
 66 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Glossary of statistical terms

Key statistics and useful Excel formulas
Introduction
MODULE 1

You do not need to be an expert in statistics to derive useful insights from historical data and apply
those insights into practical risk management approaches to real-life problems. Excel spreadsheets
provide fruitful resources for:
• determining the volatility (standard deviation) for historical data;
• creating random distributions;
• overlaying hedge strategies;
• computing confidence intervals; and
• Monte Carlo simulations.

Later modules will provide more detail on specific financial instruments which can be used to
build upon the material in this module.

Volatility
Volatility is an important measure in financial risk management as it measures how much a
variable moves over a time period. The volatility of a commodity price, exchange rate or interest
rate can be calculated through use of a historical data set, enabling the standard deviation to
be computed.

Standard deviation
Standard deviation is the way volatility is usually calculated in finance. The common method
of calculation for historical volatility is the standard deviation of logarithmic returns. Standard
deviation is a statistical term used to describe dispersion (also called variability) in a data set.
It has an exact formula, being the square root of variance. In other words, it is the square root of
the average squared deviation from the mean.

The Excel formula for computing standard deviation is: =STDEV(data range).

Normal distribution
A normal distribution assumes a random distribution of outcomes around a central point (the mean)
based on the given standard deviation. The normal distribution looks like the shape of a bell,
as shown in Figure 1.19. The larger the standard deviation relative to the mean, the flatter the bell
curve. Given the constant shape of a normal distribution, it is possible to forecast the likelihood
of outcomes in the different parts of the normal distribution based on the number of standard
deviations from the mean.

Figure 1.19 highlights what the expected percentage is for the different sections of the distribution.
For example, 95 per cent of the expected population will fall within plus and minus two standard
deviations from the mean. Likewise, only 2.5 per cent of outcomes will fall into the area above plus
two standard deviations. Excel provides a formula to determine the percentage of the population
that falls within or below a certain range.
 Study guide | 67

For example, if you look for the percentage of the population that falls below +1, assuming
a mean of nil and a standard deviation of one, the Excel function for the normal distribution
(NORMDIST) will have the following inputs:

MODULE 1
The result is 84 per cent (0.5% +2.0% + 13.5% + 34% + 34%), which corresponds to the area to
the left of the +1 standard derivation in Figure 1.19.

Alternatively, it is possible to determine the number of standard deviations that correspond to a

specific probability via the Excel function for inverse of the normal distribution (NORMSINV):

This reveals that 84 per cent of a normal distribution sits below approximately one standard
deviation above the mean.

Figure 1.19 illustrates the approximate percentage of a normal distribution falling within one,
two and three standard deviations.

Figure 1.19: Normal distribution

0.5% 2.0% 2.0% 0.5%

13.5% 34% 34% 13.5%

–4 –3 –2 –1 0 1 2 3 4

68%

95%
99%
 68 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Value at risk (VAR)

Value at risk (VAR) is a widely used risk measure of the risk of loss over a given time frame. VAR is
used by risk managers in order to measure and control the level of risk which the organisation
undertakes. Value at Risk is measured in three variables: the amount of potential loss, the probability
of that amount of loss, and the time frame. VAR is therefore used in computing the likely loss with
MODULE 1

a degree of confidence. Hence a 97.5 per cent VAR will be the statistically derived loss suffered at
two standard deviations from the mean for a given time period.

Figure 1.20: Normal distribution—VAR at 97.5 per cent confidence

VAR at 97.5%

0.5% 2.0% 2.0% 0.5%

13.5% 34% 34% 13.5%

–4 –3 –2 –1 0 1 2 3 4

68%

95%
99%

For example, refer back to Case Study 1.3 on Bright Gold Corporation. To determine the degree
of variation in profit with 95 per cent confidence for display in the Tornado chart, a variation of
VAR was used: plus or minus two standard deviations over the one year. In other words, based on
the standard deviation and the one-year time horizon, 95 per cent of outcomes are expected to
occur in the banding.
 Reading 1.1 | 69

Reading

MODULE 1
Reading

Reading 1.1
AWA and foreign exchange exposure management

Introduction
AWA Ltd is a well-known and well-regarded Australian company specialising in electronics and
associated industries.

In 1986/87 it was under considerable pressure, including takeover threats and exposure to the
highly volatile foreign exchange markets (with the Australian dollar only floated in December
1983, there was considerable uncertainty as to its vulnerability).

The case is important for many reasons, one of the main ones being the fact that it was not settled
out of court and, therefore, the facts and findings are in the public arena.

The following study looks at the case as it unfolded from the viewpoint of the directors. This is a
most important perspective for treasurers/CFOs and treasury specialists to understand, for it has
substantial ramifications for the structuring and conduct of all treasury operations.

The facts of the case

AWA commenced its foreign exchange operations in late 1985, appointing a 23-year-old accountant,
Andrew Koval, as its foreign exchange and money market manager. AWA had significant exposures
to imports, particularly from Japan, originally estimated to be around AUD 200 million per annum.
In fact, if currency adjustment clauses were taken into consideration, particularly with Telecom and
the Department of Supply, the exposure falls to well under AUD 100 million.

Andrew Koval managed the company’s exposures for a period of 18 months. However, he first
came into prominence in October 1986 when it was revealed that foreign exchange ‘profits’ of
around AUD 7 million had been made by AWA in the 1985/86 financial year.
 70 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

The November 1986 board meeting

A profit of AUD 10 million had been budgeted for the 1986/87 year from foreign exchange hedging.

Andrew Koval attended a November 1986 board meeting to explain to the directors his methods.
This was the first occasion on which the chairman and CEO, John Hooke, had met Andrew Koval.
MODULE 1

It was the only occasion on which other board members ever met him.

Koval’s presentation to the board was based on forecasting currencies and on rolling hedges
(i.e. extending their maturities at/around their original exchange rates, regardless of current
exchange rates), also called historical rate rollovers.

The February 1987 board meeting

In his interim judgment, Mr Justice Rogers (IJ 1992, p. 52) included the following extract from an
annexure to the general manager’s report to the board of 9 February 1987:
1. Total foreign exchange profits for six months to December 1986—AUD 13 381 608.
2. January 1987 realised profits—AUD 12 651 653.
3. Unrealised profits in addition—AUD 11 598 535.
4. Total profits for the year to date—AUD 39 028 482.

This report ‘startled’ one non-executive director and ‘alarmed’ another. A third described
the figures as ‘almost unreal’ (IJ 1992, p. 147).

But what was the board to do about it? Mr Justice Rogers (IJ 1992, p. 149) stated he believed that
the board had only three realistic choices:
1. ‘Have the auditors confirm that the profits which were being reported were in fact actually
being realised …’;
2. ‘Close down the operation completely’; or
3. ‘Call in an independent expert’.

The first option was followed in part. The auditors confirmed that profits were actually being
realised, that ‘the operations carried no risk, that stop loss orders were in place and that open
contracts were restricted to an exposure of no more than two years exposed purchases’.

The second option (to close the treasury) ‘seemed foolhardy in the extreme’. The area was
making excellent profits and the auditors had given the area an apparent all-clear.

The third option—to call in an independent expert—was not taken, but with management
assurances that all was well, and with a general reluctance to offend Andrew Koval, the directors
decided only to monitor the situation carefully, that is, to do nothing at that stage.

On 9 March 1987, AWA announced a 50 per cent increase in pre-tax profits for the first half of the
1986/87 financial year, with all growth coming from foreign exchange operations—AUD 10 million
of the total of AUD 16.1 million reported. Mr Hooke was reported in the Financial Review
(1987, p. 42) as stating:
Growth in the half came from the foreign exchange trading, which also contributed much of the
growth in its 1985/86 year.
 Reading 1.1 | 71

Mr Hooke was also reported in the same article as stating that AWA had developed a profit
centre in its foreign exchange management,
It was trading on the forward cover contracts taken out for its Japanese sales, but Mr Hooke said
AWA was being very cautious and was trading on the $US–Yen rate, not on the Australian dollar.

MODULE 1
Board meeting 30 March 1987
The directors requested the partner in charge of the external audit, George Daniels of Deloitte
Haskins and Sells, to attend the board meeting to discuss the foreign exchange position.

The deputy chairman, Sir Peter Finlay, opened the discussions by stating that the board had
great concerns about the foreign exchange operation. Sir Peter said:
The directors want to be reassured by you that you really have dug into the whole area and that
we are not kidding ourselves in accepting these figures presented to us in the monthly accounts.
Daniels responded by acknowledging an awareness of the Board’s concerns and went on ‘We have
done so [looked very hard at the area of foreign exchange operations] and we are satisfied that
there is nothing funny about the figures … the reported profits have been realised (IJ 1992, p. 161)’.

Board meeting 11 May 1987

At this meeting a video of a Channel 9 program on AWA’s foreign exchange operations was
screened. It showed a very profit-oriented, confident and assured Andrew Koval at work (and play).
The directors were ‘disturbed’. The directors asked the recently appointed general manager
finance, Barry Wickham, if Andrew Koval was ‘under control’. He replied in words to the effect that:
I am getting on top of the job but Koval is a difficult young man and it is necessary to handle him
with kid gloves. Koval has been offered fancy salaries from alternative employers and it is getting
critical that Koval is not lost to AWA. Koval is a real expert and there are limits as to how much
day‑to-day control I can assume (IJ 1992, pp. 164–5).

A full report from Mr Wickham on foreign exchange operations was requested. Mr Wickham,
it should be noted, had no previous foreign exchange experience, but this was not known by
the Board.

The two crashes

• Crash 1: In May 1987, Andrew Koval was involved in a car accident which resulted in a
two week absence from AWA. In that period, there was a significant adverse movement in
the currency markets. On his return, Koval’s treasury was in a very poor financial position,
which he attempted to trade out.

• Crash 2: In late June 1987, a financial advisor from Lloyds, Dr Parkes, was shown some papers
from Mr Wickham, in the company of Mr Hooke. Included was a paper that noted open
positions of around AUD 800 million. It was a matter of less than a week before an outside
expert was brought in and Andrew Koval was virtually removed from operational control.
He left the company in mid-July.

The actual exposures July 1987

When the exposures were aggregated at the end of June 1987, open positions were around
AUD 1.1 billion. In October 1987, AWA announced losses of AUD 49.2 million on foreign exchange
dealings for the 1986/87 year, dominating their overall loss of AUD 9.6 million for the year.
The following month they commenced legal action against the auditors.
 72 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

The litigants
The principal proceedings were brought by AWA Ltd (AWA) against the partners of Deloitte
Haskins & Sells (DHS), alleging a breach of contract by DHS in relation to the conduct of
two audits, the first being for the year ended 30 June 1986 and the second for the half year
to 31 December 1986.
MODULE 1

Cross claims were then made by DHS against:

1. AWA Ltd (contributory negligence)
2. AWA executive director—Mr John Hooke (MD)
3. AWA non-executive directors Sir Peter Finlay
Mr Jack Campbell
Mr David Anderson
4. Two of AWA’s bankers Westpac
Lloyds (for unauthorised loans and some audit deficiencies)

The judgment
Over four-and-a-half years later, following 60 days of sittings, and legal costs estimated at
around AUD 30 million, an interim judgment was delivered on 3 July 1992.

Mr Justice Rogers found in summary that:

1. Deloitte Haskins and Sells were negligent.
2. AWA Ltd, however, was found to have significant contributory negligence.
3. Mr Hooke, the executive director, was negligent.
4. The case against the non-executive directors was dismissed.
5. The case against the banks (Westpac, Lloyds) was dismissed.

The judgment itself covered 280 pages, but in his initial synopsis Mr Justice Rogers made the
following points:
1. The auditors were negligent as early as 22 September 1986.
2. AWA Ltd contributed to this negligence by its inadequate records and managerial
supervision and as such were partially to blame for the damage.
3. Auditors were faced with two conflicting pressures:
(i) the need to tender competitively for jobs; and
(ii) the increase in expectations as to their role as a watchdog.
4. It was ‘ironic’ (Rogers CJ) that AWA Ltd’s new management should spend so much time
and money proving how inefficient were the previous management’s foreign exchange
procedures—a fact that was ‘glaringly obvious’.
5. It was also extraordinary that in a dispute of this length and cost, a just result was expected
without hearing from the principal participants (e.g. Mr Koval was not called as a witness
by any party; in fact, only Mr Hooke and one other senior member of AWA’s management
gave evidence).
6. The board of AWA was ‘entitled to believe’ the assurance of such a distinguished auditing
firm as DHS. Unfortunately, its work, particularly its signing off the half year profit to
December 1986, was not up to standard.
7. While both auditors and management agreed to the necessity of a foreign exchange
procedures manual being prepared as early as September 1986, no such manual was
ever prepared.
8. The DHS auditor in March 1987 decided to circularise all financial institutions for details of
their transactions with AWA but signed the statutory profit statement before receiving all
replies and with evidence of unrecorded foreign exchange loans already in his possession.
9. DHS failed to inform the Board of AWA of ‘gross defects’ in AWA procedures. Mr Justice
Rogers found this ‘beyond understanding’.
10. Auditors were legally obliged to assess the adequacy of a client firm’s internal control and
accounting systems. A failure to do so was construed as negligence.
 Reading 1.1 | 73

11. If deficiencies were discovered, they should be raised with an appropriate level of
management. If management did not respond adequately, there was a legal responsibility
to go to the Board. In the AWA case, the systems and controls were totally ineffective.
12. Auditors must be technically competent in such areas as foreign exchange.
13. Auditing standards as published by professional bodies constitute a reasonable benchmark

MODULE 1
for determining acceptable behaviour.
14. Auditors may, if sued, cross claim against the company on the grounds of contributory
negligence.

Non-executive directors
Mr Justice Rogers found that the board had set a general foreign exchange policy in early 1986,
even though it was not in writing or specifically stated in Board minutes. He found that this policy
of low-risk activity was understood by management and it was up to management to devise and
implement strategies, systems and controls.

Further, the three non-executive directors each had some financial background. Sir Peter Finlay was
deputy chairman of the National Australia Bank. Mr Peter Anderson was chairman of Chase AMP.
Mr Jack Campbell had been an executive director of CSR to 1985 and was a former deputy
secretary of the Department of Trade and Industry.

In dismissing the claims against the non-executive directors, Mr Justice Rogers conflicts strongly
with the proposed changes to the Corporations Law.

The board had requested and received assurances from management and the auditors that its
policy was being followed and that all was well.

As Professor Austin (1992) stated in a presentation to the Australian Institute of Company

Directors:
In the AWA case the non-executive directors were protected by Rogers CJ’s findings of fact that
they established a policy on FX transactions and frequently expressed concern and obtained
reassurances. Anything less than this level of activity and concern may have exposed the
non‑executive directors to personal liability.

Senior management and executive directors

The primary responsibility for ensuring that there were adequate controls was found by
Mr Justice Rogers to rest with management (not the auditors). However, at AWA no one
was technically competent to do so, either in a trading or in an accounting sense. To quote
another legal opinion, that of Mr Leigh Brown (1992) of Minter Ellison, at a presentation to the
Overseas Bankers Association of Australia:
The central message from the AWA case judgment is that executive officers must accept
responsibility for supervision, and for establishing and administering adequate control systems,
especially in areas where the company’s potential exposure is high. Executive officers must therefore
be skilled in the facets of the company’s business for which they are responsible. The senior finance
and management officers of AWA had no specific skills in foreign exchange trading. They were
therefore not competent to monitor and control that part of the company’s activities.

Mr Brown continues:
For individual company executives, an implication is that if they are given responsibility for
supervision, they must consider whether they have the skills and experience necessary to perform
the supervisory task. If they do not, they should discuss the matter immediately with other
appropriate executives.

Further, Mr Justice Rogers held that auditors, when sued for negligence, could in turn sue
the directors and the company itself.
MODULE 1
 Suggested answers | 75

Suggested answers

MODULE 1
Suggested answers

Question 1.1
The Australian newspaper chain’s risks might include:
• retaining quality journalists;
• expanding readership;
• maintaining integrity in journalistic standards; and
• sustainability of newspapers in the digital age.

For a wheat exporter, the risks might include:

• weather conditions;
• crop disease;
• crop contamination from genetically modified crops; and
• maintaining liquidity between planting the crop and proceeds from harvest.

Both types of business will also be affected by business or operating risk, such as reputation
risk, IT systems risk, misdemeanours by employees and legal risk from disaffected stakeholders.
They may have different financial risks depending on their balance sheets, profitability and
arrangements with customers.

See also Case Study 1.3 ‘Bright Gold Corporation’ for further discussions on risk identification.

Question 1.2
(a) Transport company
The CFO is correct. Since the USD price for oil has been well over the levy trigger point for
many years, the price increase over the USD 30 trigger point is already being recovered
in the freight charges to the customer. So any further increase or decrease in the oil price
will increase costs but will result in a compensating increase or decrease in revenue via the
freight levy. As part of the risk assessment process, the CFO should obtain analysis of this
relationship. It may be the case that some customers are not charged the levy or the levy may
be being calculated incorrectly. Ideally, the accounting system would be structured to ensure
the relationship can be easily assessed.
 76 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

(b) Service station chain

The CFO is correct as the service station is a commodity retailer with the retail sales price also
varying according to the purchase price of the fuel. Effectively, the service chain is passing the
price risk of the fuel onto the customer. While the relationship between the retail sales price
and the fuel purchase price will not be perfect—due to the ebbs and flows of competitive
MODULE 1

market behaviour—to hedge the fuel price would create more uncertainty than leaving
it floating. If the purchase price is fixed but the retail sales price continues to be volatile,
greater volatility will be experienced in the overall profit and loss result. Analysis could be
done to demonstrate the potential impact of such a decision.

This is an interesting case study as many companies are affected directly or indirectly by
commodity prices and exchange rates. Some will pass on the price risk to the customer,
such as in the transport company in part (a), but many cannot. For example, consider the
large home improvement and hardware retailer Bunnings Warehouse. There may be a 3- to
12-month lead time between contracting products from China in USD and selling them in
store. At initial contract date, Bunnings would buy stock while having an estimated AUD sales
price in mind that will appeal to customers. If the USD rises and the purchases cost more in
AUD than expected, it would be difficult for Bunnings to increase this AUD price after order
date as it may render the product uncompetitive. Careful analysis is required of whether there
is an appropriate risk treatment approach.

(c) Regulated network (utility) company

The CFO is correct. If the interest rate on the debt is locked in via a hedge for 10 years,
but the regulated fee the network company charges for the asset is determined each
five-year period based on the five-year rate, the proposal to hedge out 10 years creates a
significant mismatch between the revenue and cost position of the company. Such a strategy
would create more uncertainty, and more risk than the position of hedging out for five years
at the reset dates. The CFO should confirm this understanding by reviewing the network
charges contract and requesting an analysis of the optimal hedging approach to minimise
the risk of mismatch.

(d) Major industrial company

The CFO is correct to question the proposal, especially given the absence of a business
model projected beyond five years. The absence of the business model greatly increases
the risk that the assumptions underlying the proposal (i.e. that the debt will continue for the
next 10 years) may be incorrect. In addition, the proposal makes the explicit assumption that
interest rates will increase when in fact they may fall further. Such a proposal would require
consideration as to whether a reliable business model could be created to cover the period
of the proposed hedge and whether alternative hedge arrangements might better match
the risk appetite of senior management and the board.
 Suggested answers | 77

Question 1.3
This question requires you to visually interpret the expected outcomes of each hedging
strategy. It does not require a detailed understanding of each derivative or of particular hedging
strategies. These are covered in more detail in later modules.

MODULE 1
Looking at the graph it is possible to ascertain the following about the four different hedges.

100 per cent swap

The 100 per cent swap fixes the interest rate at 4 per cent and locks the interest expense in at
$0.4 million. It has the advantage that it provides the minimum amount of variability. Hence, it is
the most effective hedge to reduce uncertainty or interest rate risk. It has the disadvantage that it
does not allow any participation in a reduced interest rate expense if interest rates fall.

50 per cent swap

The 50 per cent swap reduces the distribution of outcomes compared to the unhedged position,
but not as much as the 100 per cent swap position. It has an advantage over the 100 per cent
swap as it permits some participation in reducing the interest expense when interest rates fall.
However, it has the disadvantage that the interest expense will increase as interest rates rise.

Collar
The collar has a limited advantage of reducing the interest expense down (to a floor of $0.35 million),
but its disadvantage is that if interest rates increase, there is potential for the interest expense to
increase (to a cap of $0.45 million). The distribution indicates a higher frequency of outcomes at
the two extremes of the collar, with a slightly higher frequency of outcomes at the higher interest
expense.

Option
The option has the advantage of permitting full participation in any downward movement in
interest rates whilst capping the cost at just under $0.5 million. It has the disadvantage of higher
interest expense more frequently than a swap due to the costs embedded in the option price.

There is no correct answer for the hedge strategy. All of the strategies are effective in managing the
interest rate expense. It is up to senior management and the board to consider the implications of
each strategy before making an informed decision. Based on the facts provided, the 100 per cent
swap is recommended as it is simple to understand, most effective in reducing risk and relatively
easy to account for.

Question 1.4
The main change in the risk bubble graphs (pre- and post-controls) is the change in consequence
as a result of the action plan initiated to manage interest rate risk. Even though interest rates will
still change, and the likelihood of interest rate risk remains, the impact on the company has been
reduced to a low level of risk.
 78 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Question 1.5
The exporter of gold statuettes to Los Angeles may not be exposed to USD currency risk if:
• the exporter had nominated the USD as its functional currency;
• the contract to sell the statuettes included any commercial clause that in effect transferred
MODULE 1

the currency risk to the purchaser of the statuettes. These price revaluation clauses are
common in international trade;
• there were offsetting USD exposures, such as the use of USD borrowings to fund the export
contract in the first place. Net exposure would be limited to the profit margin; or
• financial risk management had been undertaken to neutralise the exposure by, for example,
the sale of the USD revenue via forward exchange contracts.

Question 1.6
(a) The danger signs
1. Reporting hedging results as profits
If indeed the exposure management involved is a genuine hedge, there must be an
underlying exposure to link to the hedge. Speculation occurs only if the net position exceeds
the underlying exposure—as Mr Justice Rogers pointed out in his interim judgment (AWA Ltd
v. George Richard Daniels T/As Deloitte Hoskins & Sells (1991) NSW SC 50271 at 34). IAS 39
requires transparent documentation that will clarify whether a derivative is a hedge or a
speculative transaction.

To divorce exposure management from the underlying exposures may result in serious errors
of judgment.

2. Treasury-based incentives
Koval was paid a bonus based on his trading profits (of around twice his base salary). This biased
him towards very active trading and to rolling forward (unrealised) losses where possible.

It may be useful to revert to theory for a moment.

Once a company takes a market decision to export or import some items of either a current
or a capital nature, it creates a financial asset or liability. That financial asset/liability can be
priced in the market (e.g. an export contract). Treasury may then either purchase it from the
business unit (forward contract) or insure it against some event or combination of events
(option). If treasury prices fairly, it should only be able to subsequently sell the financial asset
at the fair market price.

Treasury will therefore generally only be able to make profits if it either:

(i) misprices the financial asset/liability in the first case; or
(ii) adopts a higher risk profile in trading the exposure.

In the first case, there is no added value to the firm—it is merely a form of transfer pricing.
In the second case, it has changed the nature of the risk–return trade-off faced by the firm.

If the board does not want to encourage either of these sets of behaviour, it should not
set treasury-based incentives, but rather incentives based on the overall performance of
the company.
 Suggested answers | 79

3. Using forecasts as budgets

This is a common but dangerous trap of using forecast-based strategies. Consider the
forecasting performance of 36 leading economists over the relevant period (see Figure 1.15).

Such a targeting technique is divorced from the underlying business itself. The real

MODULE 1
question revolves around the identification of those exchange rate levels that are critical
to the firm’s achievement of its business goals. It also highlights the importance of running
scenarios based on randomly generated exchange rates given the difficulty of forecasting
currency rates.

4. Budgeting for profits from foreign exchange trading

Of AWA’s 1986/87 profits, 25 per cent were forecast (budgeted) to come from foreign
exchange trading. This was from a unit where one professional officer (Andrew Koval) was
the only person authorised to deal on AWA’s behalf.

5. Uncontrolled staff
Within three months of commencing the exposure management system, only Andrew Koval
could run, or even understand, the system being used.

6. No divorce of dealing and confirmation (inadequate segregation of duties)

Andrew Koval often authorised or checked his own deals. More significantly, if there
was a discrepancy found by another staff member, it was given to Mr Koval to reconcile.
This practice is a very common one in corporations even today and remains fraught with
dangers. Unless every inconsistency is logged separately and controlled by an independent
party, accidental or deliberate fraud is relatively straightforward. Operational controls over
the segregation of duties are discussed in Module 8.

7. No independent assessment of treasury

Auditors are not normally equipped to examine the strategic or even operational aspects of
a treasury operation. Their main task is to ensure correct accounting procedures are followed.
IAS 39 requires that detailed records be maintained to clarify the exact nature of each
hedging relationship (at the time of the incident, IAS 39 did not exist). This is a major topic
in Module 7.

As Justice Rogers pointed out in his report (AWA Ltd v. George Richard Daniels at 149),
if the directors had taken such action in February 1987, a Pandora’s box would have
quickly opened.

(b) Checklist for directors

Six questions—or more accurately, three pairs of questions—may assist in giving directors a first
approximation of the financial fitness of their treasury operations.

1. Are forecast rates used to set the budget?

Obviously, some rate has to be used for planning purposes, but are you biasing treasury towards
a calculated guess? The second question that therefore needs to be asked is as follows.

2. Are foreign exchange trigger levels preset?

If they are, the company is normally under control. If not, a re-examination of the company’s
exposures, sensitivities and ultimately its goals is strongly recommended. Link exposures to
goals, not to forecasts.

The second pair of questions relates to the technical aspects of treasury.

 80 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

3. Is treasury’s report to the board in clear English?

Consider the following explanation by a treasury officer of a large British company as an
example of exposure management.
We wanted to hedge a long £ position in a trendless market. We thought of buying £ puts but
volatility was near its all time high so instead we sold £ calls. Sterling in fact began to rally and
MODULE 1

we closed the underlying long position for a profit leaving us with a short call exhibiting a 65–70
delta. We could have bought the call back at a loss, but felt that sterling would probably soon
run out of steam and be range trading for the rest of the life of the option and, consequently
sold out-of-the-money puts on sterling (i.e. we were bearish on volatility and still mildly bullish
on spot). At expiry the premium we received on the puts paid for the in-the-money-ness of
the short calls so that eventually we were able to make money on the hedge as well as the
underlying long position. This is one example of how options can be used to net down the cost
of hedging (Brady 1991, pp. 25–26).

The above quote is from a paper written by the assistant treasurer of Allied Lyons plc—a
company that announced foreign exchange losses of GBP 147 million (AUD 360 million) from
taking option positions on the basis of forecasts of movements in the USD around the time of
the first Gulf War in the early 1990s (a similar period to the AWA court case). Such a statement
would be unintelligible to most financial institution boards, let alone organisations whose
main function is not financial in nature. Importantly, unless the position was stress tested as
part of the approval process, it is unlikely the board would have understood the worst-case
impact of the position.

4. Are options too risky or expensive?

After the previous section one may be tempted automatically to answer ‘yes’. However,
that particular treasury took on a market-making role and sold options. Normally,
an organisation only sells an option as part of an overall risk management program.
Overwhelmingly, organisations are buyers, not sellers, of option strategies.

Options are designed to buy and sell risk. As such, they cannot, by definition, be too risky.
They are priced at the market’s assessment of the cost of managing that risk. If you consider
them too expensive, you believe the market’s assessment or valuation of risk is incorrect.
Option price formulae do not include forecasts—only estimates of volatility.

5. Is there a treasury procedures manual?

In itself, the existence of such a manual signifies little—it may or may not be being followed.
On the other hand, if no manual exists it leaves treasury open to making its own interpretation
of its role and this can lead to serious failures in communication. Given the detailed
requirements of IAS 39, it is expected that most companies will have a procedure to explain
their hedging strategies and how they fit with accounting standards. This will also be of
assistance to the accountants and auditors of the company because it will enable both to
better understand the strategies and objectives of hedge positions.

A tougher test is as follows.

6. Is it compulsory for all treasury staff to take a minimum of two weeks’ continuous leave
each year?
While this is good for succession planning and very good for each individual’s wellbeing, it is
excellent as an anti-fraud device (innocent or deliberate). It is very hard to keep a problem
under wraps when you are miles away from the business. It should also be remembered that
the majority of frauds or problems start with an innocent mistake or a well-meaning project
that goes awry. In AWA’s case, it was Andrew Koval’s enforced holiday that was the beginning
of the end.
 Suggested answers | 81

Much was repeated in the cases of Pasminco and Sons of Gwalia in the late 1990s and early
2000s. (Please refer to Reading 8.1 for discussion of the Sons of Gwalia case.)

As late as 2008 this was still an issue, with the USD 8 billion Société Générale losses from
unauthorised trading partly caused by the trader’s ability to avoid taking holidays and

MODULE 1
therefore being able to continue to hide unrealised losses.

(c) G
 eneralised strategic approach to foreign exchange
management for directors
A strategic approach for foreign exchange management involves:
• determination of exposures and sensitivities;
• goal setting; and
• nesting of performance measures.

The first two are absolutely fundamental, albeit difficult to quantify in practice. A company
needs to know the overall effect of a movement in exchange rates on its total business—and
the amount of movement required before its goals are threatened. Sensitivity analysis and the
identification of critical currency levels are the hallmarks of a sound policy.

The key to effective exposure management is to know the implications of any changes in financial
prices. Once these are clearly understood, directors (not treasury) need to set goals or policies
for the company that centre on the combination of risk and return acceptable to the organisation.
As Mr Justice Rogers stated, the first of a board’s functions is to set goals for the corporation
(AWA Ltd v. George Richard Daniels at 250–1). Then and only then can effective performance
measures be set to bias all parties towards achieving these goals.

While this process may only be necessary for the board to do once a year—thereafter delegating
continuing exposure management to treasury and/or the business units—it is the critical stage of
the strategic due diligence process (i.e. corporate governance) in the exposure management area.

Once policies/goals have been set, it is essential that both the business units and treasury set
benchmarks and performance measures that encourage them to achieve the policy targets.

Thus, the goals and the performance measures set need to be ‘nested’—that is, to be
interdependent. The goals of the board, of the business units and of treasury should
be congruent.

One of the unforeseen negative consequences of the AWA case, the Sons of Gwalia case
and, importantly, changes to the Corporations Act 2001 (Cwlth), has been a tendency for boards
to close down their treasury’s strategic areas and retain only their administrative and control
functions. After all, in AWA’s case, three of the four directors involved were also directors of
banks, yet they still had a treasury that was virtually out of control.

In Australia, there have been periods when around one treasury a month has been subjected
to a major downgrading. To ‘do nothing’ is presumably deemed safer than to permit trading in
markets outside the directors’ perceived comprehension or control. Yet to do nothing is in fact
a highly risky strategy and should only be undertaken, if ever, as a deliberate policy rather than
as a form of default. It is a sin of omission, rather than commission.
 82 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

The other extreme position is also risky. If treasury is to be seen as a general profit centre, it must
be handled as a major project and run as a fully functioning business unit. However, a board
should be extremely careful about making such a move. A word of warning from a leading
treasury specialist:
Before setting its own financial hedging objectives, a firm must ask itself the key question:
MODULE 1

‘Could we profitably exist as a purely financial institution?’. Honest introspection would reveal that
most companies earn their keep because of their superior marketing, production, organisational
and technological skills. This implies that the task of financial personnel is to manage a firm’s
financial affairs; that is, its job is subordinate to the ‘real’ business of the firm which is to produce
and sell goods and services (Shapiro 2009, p. 242).

A further message of caution:

The idea that the corporate treasurer should be a star performer in the company, out there to
maximise the return he can obtain on gambling the company’s money, is fundamentally mistaken.
He should be more like the goalkeeper of the team, protecting the rest of them against unwanted
attack from external forces in order that they can get on with what they do best. Few teams are
grateful to the goalkeeper who takes advantage of possession of the ball to lead his own personal
attack on the other side (Thiry 1991, p. 50).

Rather, the treasury should be used as a tool to achieve the organisation’s goals. Once the
board has determined its desired risk–return trade-off and set goals and performance measures
designed to achieve this, treasury will normally become a means to an end, not an end in itself.

Question 1.7
There are arguments for and against hedging. Hedging is just one tool to enable a company
to achieve its goals and objectives. Hedging provides short-term certainty, but cannot protect
an organisation from market forces in perpetuity. Hence, the decision to hedge financial and
commercial risks is a matter for the board to consider based on:
• the goals and objectives of the organisation;
• an analysis of the financial risks and the cash flows/value of the organisation;
• an analysis of the potential scenarios faced by the organisation and the strength of its capital
structure to absorb risks; and
• the risk appetite of the organisation.

It is critical that the full five-stage analysis outlined in Figure 1.2 be performed prior to the decision
being made. Once made, it should be documented and communicated to key stakeholders.

Question 1.8
Answer: (d)

The global price is set in USD. Hence, movements between the AUD and the USD, as well as the
actual price of wheat, will affect the AUD price. Also, clients do not always pay in a timely manner,
which can impact the cash position and liquidity of the organisation.
 References | 83

References

MODULE 1
References

ASX (Australian Securities Exchange) Corporate Governance Council 2014, Corporate

Governance Principles and Recommendations (third edition), ASX, Sydney.

Bergsten, C. F., & Gagnon, J. 2012, ‘Currency manipulation, the US economy, and the global
economic order’, Peterson Institute for International Economics Policy Brief, no. PB12-25,
December, accessed August 2013, http://www.iie.com/publications/pb/pb12-25.pdf.

Brady, S. 1991, ‘Allied Lyons deadly game’, Euromoney, April, pp. 22–28.

COSO (Committee of Sponsoring Organizations of the Treadway Commission) 2004, ‘Entreprise

risk management—Integrated framework: Executive summary’, accessed August 2013,
www.theiia.org/iia/download.cfm?file=9229.

Eley, J., Moore, E. & Powley, T. 2012, ‘Rock collapse left many in a hard place’, Financial Times,
14 September, accessed August 2012, http://www.ft.com/cms/s/0/2abdeb34-fda8-11e1-8e36-
00144feabdc0.html#axzz2ceTZBrBE.

G20 2009, G20 Summit on Financial Markets and the World Economy, US Government,
Washington, D.C.

IMF (International Monetary Fund) 2008, Articles of Agreement of the International Monetary Fund,
IMF, Washington, D.C., accessed August 2013, http://www.imf.org/external/pubs/ft/aa/pdf/aa.pdf.

Northern Rock plc 2006, Annual Report and Accounts 2006, accessed October 2014, http://www.
n-ram.co.uk/~/media/Files/N/NRAM-PLC/documents/corporate-reports/res2006pr-annualreport
andaccounts.pdf.

Shapiro, A. C. 2009, Multinational Financial Management, 9th edn, Wiley, Hoboken, New Jersey.

Shin, H. S. 2009, ‘Reflections on Northern Rock: The bank run that heralded the global financial
crisis’, Journal of Economic Perspectives, vol. 23, no. 1, pp. 101–19, accessed August 2013,
http://www.jstor.org/stable/27648296.

Standards Australia/Standards New Zealand 2009, AS/NZS ISO 31000:2009 Risk Management—
Principles and Guidelines, Standards Australia, Sydney/Standards New Zealand, Wellington.
 84 | INTRODUCTION TO FINANCIAL RISK MANAGEMENT

Thiry, B. 1991,‘Do you know what your finance director does?’, Business Strategy Review,
vol. 2, no. 3, pp. 39–52.

RBA (Reserve Bank of Australia) 2013a, ‘Historical exchange rates’, accessed August 2013,
http://www.rba.gov.au/statistics/hist-exchange-rates/.
MODULE 1

RBA (Reserve Bank of Australia) 2013b, ‘Statistical tables’, accessed August 2013,
http://www.rba.gov.au/statistics/tables/#interest_rates.

RBA (Reserve Bank of Australia) 2013c, ‘Commodity prices’, accessed August 2013,
http://www.rba.gov.au/statistics/frequency/commodity-prices.html.

Optional reading
Smithson, C. 2004, ‘Does financial risk management increase shareholder value?’, CIBC School of
Finance, June, accessed May 2008, http://www.rutterassociates.com/pdf/Does_Financial_Risk_
Management.pdf.
 FINANCIAL RISK MANAGEMENT

Module 2
MANAGEMENT OF LIQUIDITY,
DEBT AND EQUITY
MICHAEL HEFFERNAN AND ASJEET S. LAMBA
REVISED BY RICHARD ALLAN*

* The authors acknowledge the use in this module of content previously prepared by Richard Tress,
Adam Forster and Adam Steen.
 86 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Contents
Preview 89
Introduction
Objectives

Part A: Cash flow management 92

Liquidity management 93
Cash management 95
Cash disbursements 97
Free cash flow 98
Stress testing 99
MODULE 2

Part B: Working capital management 100

Strategies to manage working capital 100
Statement of financial position relevance to cash management: Stocks versus flows
Factoring
Measuring working capital requirements 103
Credit risk assessment 107
Nature and measurement of credit risk

Part C: Sources of funds for business 113

Money market instruments 113
Bills of exchange and bank bills
Promissory notes (commercial paper)
Negotiable certificates of deposit
Money market instruments in practice
Pricing discount securities
Other sources of short-term and intermediate-term finance 117
Bank overdraft
Fully drawn advances
Term loans
Trade finance
Equipment financing
Long-term debt financing 120
Types of instruments 122
Bond markets
Government and semi-government bonds
Corporate bonds
Other forms of capital raisings
Debt restructuring
Negative pledge borrowing
Seniority of debt instruments
Offshore long-term debt and equity fundraising 127
Foreign bonds
Euro-markets
Eurobonds
Types of Eurobonds
US markets
US private placements and ADRs
Asian markets—Japan
Equity financing 131
Debt versus equity and the GFC
Forms of equity financing 133
Ordinary shares
Bonus shares
Venture capital
Listed and non-listed companies
Mechanisms for raising equity capital
Hybrids: Equities and securities
Reason for the issue of hybrid securities
Implications for funding and capital management planning
 CONTENTS | 87

Part D: Funding for specific types of business structures 141

Funding for sole traders and partnerships 141
Funding for private companies and other small to medium
enterprises (SMEs) 142
Public companies 143
Requirements for entities wishing to list on the ASX
Advantages and disadvantages of listing on the ASX

Part E: Legal requirements for raising funds from the public 145
Pre-float preparations 145
Australia 145
Offshore capital raising 146

MODULE 2
Review 148

Suggested answers 149

References 153
Optional reading
MODULE 2
 Study guide | 89

Module 2:
Management of liquidity,
debt and equity

MODULE 2
Study guide

Preview
Introduction
This module provides an overview of the:
• procedures involved in effective cash flow and working capital management;
• various methods by which organisations raise funds;
• different markets which may be accessed to raise funds; and
• suitability of funding method for various types of businesses.

Before discussing the sourcing and management of debt and equity funds, it is important to
cover the background and current developments following the global financial crisis (GFC)
in 2007–08, in particular Basel III. This is also important as there are consequences for Australian
capital markets and therefore the Australian financial and corporate sectors.

Prior to the GFC in 2007–08 there were historically high levels of leverage in global financial
markets. That is, equity as a proportion of total capital utilised had declined substantially.
Collateralised borrowing and securitisation was rife and there was a big increase in hybrid
products (explained later in this module) and internally leveraged financial products.
Counterparty risk increased and ratings became questionable.

Since then the reaction of governments, regulatory authorities and private organisations has
been to increase the equity base where possible and to engage in a de-leveraging of their
balance sheets. One of the first groups to act decisively was the Basel Committee on Bank
Supervision (Basel Committee or BCBS), which initially in December 2010 and subsequently
in 2011, announced its intention to enforce an international framework that comes under the
umbrella title of ‘Basel III’. Under Basel III, banks will be better equipped to handle stresses
on credit and liquidity. In April 2013, the BCBS extended the implementation date to March
2019. Australia’s central bank, the Reserve Bank of Australia (RBA), endorsed these proposals
(to be phased in from 2016), with the aim that these will improve market stability and strengthen
Australia’s capital and securities markets.
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The Basel Committee’s two key international minimum standards for liquidity risk are:
• Liquidity Coverage Ratio (LCR): A short-term resilience test to ensure a bank has sufficiently
high-quality liquid assets to survive a significant stress scenario lasting for 30 days; and
• Net Stable Funding Ratio (NSFR): A stable funding test similar to the LCR except the period
over which it is tested is one year.

The high-quality liquid assets that can be counted towards the LCR under Basel III fall into
two categories:
• Tier 1 assets: These assets are limited to cash, central bank reserves that can be drawn down
in times of stress and certain categories of government debt. Level 1 assets can comprise
an unlimited share of the liquid asset pool for the purposes of the LCR and are not subject
to a haircut (the difference between the prices at which a market maker can buy and sell a
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security) under the LCR.

• Tier 2 assets: These assets include certain other categories of government debt, highly rated
corporate bonds (issued by non-bank issuers) and covered bonds. Level 2 assets may not
comprise more than 40 per cent of the overall liquid asset pool for the purposes of the LCR.

These tests have significant implications for Australia, as it has a small and by international
standards relatively low level of government debt which may result in an insufficient supply of
Level 1 assets as well as a relatively short supply of Level 2 assets.

As a result, the Reserve Bank of Australia (RBA) intends to provide committed liquidity facilities to
the major Authorised Deposit-taking Institutions (ADIs) for a fee. Such facilities will count towards
the LCR requirements for around 40 ADIs under RBA supervision.

Eligible assets under the RBA’s open market operations currently include the following Australian
denominated securities, provided they satisfy certain prescribed conditions: asset-backed
commercial paper (ABCP), ADI-issued debt securities and residential mortgage-backed securities
(RMBS), commercial mortgage-backed securities (CMBS) and some other asset-backed securities.

At present, all ADIs are required to meet:

• 4.5 per cent Common Equity Tier 1 ratio (increased from 2% under Basel II);
• 6.0 per cent Tier 1 capital ratio (increased from 4% under Basel II); and
• 8.0 per cent total capital ratio (which remains the same as under Basel II).

This has significant consequences for Australian capital markets and therefore for the Australian
financial and corporate sectors. The demand for highly rated Australian asset-backed commercial
paper (ABCP), residential mortgage-backed securities (RMBS) and commercial mortgage-
backed securities (CMBS) amongst Australian ADIs is likely to increase as the RBA will permit
these assets to be used as security to borrow under the relevant ADI’s liquidity facility with the
RBA. In addition, corporate bonds (to be discussed later in the module) are probably likely to
satisfy the Tier 2 asset requirements of Basel III if they have a credit rating of at least AA, and are
actively traded.

These are major developments for all Australian capital markets, with flow-on consequences for
all financial markets, from short-term money markets to equities.

This module will provide an overview of all markets and discuss the implications for the sourcing
and management of debt and equity in both the public and private sectors.
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Objectives
At the end of this module you should be able to:
• explain and apply the concepts of cash flow and working capital management;
• explain the various forms of short-term and intermediate-term financing;
• explain the various forms of long-term debt and equity financing;
• explain various business types and identify appropriate sources of funding; and
• discuss an organisation’s ability to access funding.

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 92 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Part A: Cash flow management

Cash flow management involves the techniques employed by an organisation to track the source
and application of short-term funds within the organisation. The objective is to provide quality
information to strategic decision-makers to ensure that payment obligations can be adequately
met, both now and in the future.

Cash flow management at its most basic level is businesses forecasting, anticipating cash
flow requirements and taking steps to service them. This can be achieved by using a simple
spreadsheet matrix of cash flow items cross-referenced and measured against relevant time
lines as to when payments are required and then ensuring there are sufficient sources of cash,
including standby lines of credit.
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How often a cash flow management report is produced and to what level of detail in relation
to the accuracy of the time and amount will be a function of the financial vulnerability of
the company. If, for instance, a business operation is facing volatile trading and/or liquidity
constraints, or deals in large and material volumes of cash flows, it may need the cash flow
management report on a daily basis. If the financial flows of the business are stable and less
volatile or indeed ‘safer’, then weekly or even monthly cash forecasts may suffice. Regardless of
the level of accuracy or frequency, the central aim of the cash flow monitoring process is to serve
as an early warning system that predicts shortfalls in cash balances that may otherwise threaten
the ability of the company to pay its obligations as and when they fall due.

The ideal enablers of cash flow management depend to a great extent on an efficient and
effective internal treasury monitoring system. To be effective, financial managers need to access
accurate company cash flow data, with full transparency and disclosure of risk factors, integrated
with all relevant business processes along the supply chain. This means that reporting at all
stages of cash-relevant business processes are integrated in a timely fashion, allowing the
expected cash flows to be forecast using information that is constantly up to date.

This collection of data in relation to cash flows then services the need for visibility and control
of data sourced both from the company’s internal infrastructure and from its commercial
transactions with its business partners.

From an internal perspective, a business should have the financial systems to track and
aggregate cash. Using standardised, integrated data, and processes for optimising accounting
reporting, combined with cash flow management analysis permits synthetic bank accounts
(and sub-accounts) to be created in order to merge the traditionally separate finance functions
of accounting and treasury. This then permits virtual real-time reconciliation of cash and
related accounts.

From an external perspective, new techniques that take advantage of the latest technologies
allow, for example, the integration of key customer payment advices into the company’s own
active cash management system at an early stage, even before actual payment is received.
In addition to supply and delivery chain connectivity with business partners, banking partners
can and do offer electronic banking support that further integrates a company’s money market,
commodity, derivative and foreign exchange flows with cash accounts.

Cash flow management is not just a static predictive process to aid liquidity management.
Even the best cash flow management systems are often inherently probabilistic or subject to
outside imperatives that are beyond the company’s immediate control or both, and in such
cases the cash flow forecast should be ‘stress tested’ to take account of the inherent risks of any
base‑case forecast. This will be discussed in more detail later.
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Stress testing, as the term implies, is the taking of a base case cash flow forecast and subjecting
it to a change of one or more underlying assumptions and observing the effect on the expected
cash flow for likely cash shortfalls and their timing. It is a sensitivity analysis of some of the more
volatile global components of a cash flow forecast, such as the impact of commodity and foreign
exchange rates on revenue and expense flows. Interest rate changes are also measured for their
effect on the cost of funding (and/or returns on investments). These stress tests can be also
varied to account for more company-specific risks, for example the impact on the cash flows of
the loss of a major customer, or where debtors take extra time to settle accounts. Stress testing is
discussed further later in the module.

The stress test should not only involve a selection of assumption changes but should also be a
more holistic risk management scenario test, for instance, a detailed plausible event affecting

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one of the company’s key performance indicators. These types of ‘what if’s’ should also be
assessed to ensure a business is not just prepared for normal trading conditions, but has the
financial, cash flow and liquidity capacity to withstand abnormal or cyclically stressed commercial
conditions at some point in the future.

Liquidity management
Organisations rarely fail from lack of short-term profitability, but can be instantly extinguished
by a lack of liquidity. Liquidity is defined as the capability of an organisation to convert financial
assets and financial facilities into cash. With respect to cash flows, liquidity is the ability of the
organisation to meet its current (short-term) obligations.

One of the chief financial officer’s (CFO) key responsibilities is to ensure that there are adequate
liquid funds available to enable the organisation to pay its obligations in a timely manner.

Liquidity management involves a combination of cash, working capital and debt management.
The treasurer or financial manager is responsible for the overall liquidity management
program and must take a proactive role in all aspects of it. An important tool in this role is the
organisation’s liquidity policy which sets out the responsibilities, guidelines and authority levels
required to ensure proper management, controls and reporting.

Effective liquidity management provides a number of benefits to an organisation, including

ensuring that the organisation has sufficient funds for planned growth and, to some extent,
for unexpected investment opportunities and unforeseen events. Improved liquidity
management can enhance an organisation’s profit and return on funds employed through
reduced borrowings, and produce a higher level of internal cash generation and more effective
use of cash resources, resulting in reduced interest expense to the organisation and a retained
or enhanced market rating.

A formal liquidity management program emphasises the importance of cash within an

organisation and gives the treasurer (or equivalent responsible executive, such as a finance
manager) a framework in which to assess and control the performance of line operations.
It provides a planning and monitoring system which controls a key asset. This information is a
necessary input for planning cash and borrowing requirements, and for effective interest rate and
foreign exchange exposure management. The organisation’s liquidity policy must specify the
minimum acceptable level of liquidity which the organisation is to meet, balanced against the
costs of liquidity.

The costs associated with maintaining liquidity include: the opportunity costs of holding
surplus cash investments; finance facility costs for surplus facilities; and interest costs of surplus
borrowings. The least expensive form of liquidity is from internally generated funds. As a result,
working capital management is an important part of any liquidity management program.
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Two commonly used ratios to measure the liquidity of an organisation are the current ratio and
the quick ratio, both of which are defined as follows:

Current ratio = Current assets / Current liabilities,

and

Quick ratio = (Current assets – Inventory) / Current liabilities.

The current ratio determines whether an organisation is able to meet its short-term debt
obligations. A current ratio greater than 1.0 indicates that the organisation can meet its short-
term debt obligations because its current assets exceed its current liabilities. The quick (or acid
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test) ratio provides a measure of the immediate cash position of the organisation. This is done by
excluding the organisation’s inventory which is not a cash item.

Cash flows can be volatile and difficult to estimate. It is often easier to forecast disbursements
with reasonable accuracy compared to forecasting cash receipts. Considerable variation can
occur between the date receivables should be received and when they are received. This can be
compounded by internal factors, such as sales managers providing overly optimistic estimates
of sales receipts. This can be overcome in part by developing a close relationship with the sales
teams to test cash receipts estimates and by analysing the past trends of cash receipts to ensure
that the forecasts of future receipts are as accurate as possible.

These ratios can also be used to compare the liquidity of different organisations in the same
industry, as illustrated in Example 2.1.

Example 2.1
You are given the following information on the statement of financial position for Herb Ltd (Herb) and
Shrub Ltd (Shrub) at 30 June 20X5. Both companies are small garden-supply operations.

Herb Ltd Shrub Ltd

Assets ($000) ($000)
Current assets
Cash 30.0 40.0
Accounts receivable 20.0 20.0
Marketable securities 10.0 20.0
Inventory 80.0 30.0
Total current assets 140.0 110.0

Non-current (fixed) assets

Plant and equipment 140.0 170.0
Total non-current assets 140.0 170.0
Total assets 280.0 280.0

Liabilities
Accounts payable 50.0 90.0
Non-current liabilities 90.0 100.0
Total liabilities 140.0 190.0

Shareholders’ equity
Issued share capital 90.0 60.0
Retained profits 50.0 30.0
Total shareholders’ equity 140.0 90.0

Total liabilities and shareholders’ equity 280.0 280.0

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Compute the current ratio and quick ratio for both organisations. Comment on the relative liquidity
of the two organisations’ operations.

Solution
The current ratios for Herb and Shrub are:

Herb’s current ratio = (30 + 20 + 10 + 80) / 50 = 2.8

Shrub’s current ratio = (40 + 20 + 20 + 30) / 90 = 1.2

The quick ratios for Herb and Shrub are:

Herb’s quick ratio = (140 – 80) / 50 = 1.2

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Shrub’s quick ratio = (110 – 30) / 90 = 0.9

Herb’s current assets are 2.8 times its current liabilities and therefore it is relatively liquid. On the
other hand, Shrub’s current assets are only 1.2 times its current liabilities, indicating potential liquidity
problems although, at present, it has enough current assets to meet its current liabilities. The quick
ratio provides a measure of the immediate cash position of the two organisations and this indicates
that Shrub may have liquidity problems because its ratio is less than 1.0.

Cash management
Cash refers to an organisation’s actual cash and near-cash holdings at a given point in time.
Near‑cash holdings include highly liquid investments such as at-call money market and bank
deposits, bank bills and promissory notes. Also included in calculating net cash balances is the
bank overdraft balance which forms an integral part of a company’s cash management process.

The main steps in cash management are as follows:

1. Forecasting and planning

Routine and realistic cash forecasts are essential for effective cash management. Cash
forecasts are the basis for determining an organisation’s future cash position and borrowing
requirements. Without proper forecasts, the management of interest rate exposures can
be reduced to guess work, as loan drawdown dates and repayments are estimated with
a rough approximation. Cash forecasts provide a benchmark against which to monitor
subsequent cash positions, and any variations to the forecast may highlight other problems
or issues which require attention. Cash flow forecasts can be employed as selection criteria
in assessing the viability of a new project or for lease-purchase decisions when seeking to
obtain capital assets. Analysing the forecast can affect the decision to take on a project,
or determine whether an organisation can afford to increase its level of capital assets in
addition to continuing day-to-day business operations.

Cash forecasts provide the early warning system of impending cash problems which allow
the treasurer time to develop plans in which to either correct the shortfall or to obtain funds
to finance it. The worst time to advise a bank manager that there will be a cash flow problem
is the day before the problem occurs. In this situation it may not be possible for the bank
to provide the additional facilities required to meet the likely shortfall. The lack of advance
notice of the problem may be seen by the bank as a sign of the organisation’s poor cash
controls and management, and can only weaken its perception of the company.
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Cash forecasts bring a management discipline into an organisation and help bring a cash
conscience to the company culture, reinforcing the importance of cash to the organisation.
At a minimum, the forecast should show the major cash flow items for the organisation.

The purpose of the forecasts is to provide the best approximations of the likely cash flows
occurring over the forecast time horizon. As with any forecast, the shorter the time horizon
the more accurate it should be, and the longer the time horizon the more approximate
the forecast. The forecast periods should be relevant to the size of the organisation and
cash flows:
–– At a minimum, a forecast system should provide forecasts for the immediate period
(e.g. month) on a day-to-day basis that are updated daily.
–– For the near term (e.g. next three months), on a weekly basis that are updated weekly.
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–– The medium term (e.g. next six to 12 months), on a monthly basis that are updated
monthly.

Forecasts need to be sent to the treasury function at least monthly. The forecast must provide
sufficient detail to enable proper analysis and relevant actions by the users of the forecast.
This needs to be balanced against the costs involved in administering detailed forecasts.

2. Daily cash procedures

The objective of the daily cash procedures is to maximise the amount of cash available for
investment. The procedures needed to accomplish this include the following:
–– Daily account balance monitoring and reconciliation showing the major variations to the
previous day’s forecast. Details of account balances and transactions are readily available
from the major banks’ computer services enabling this to be a relatively simple procedure
at both a group, treasury and business unit level.
–– Daily cash flow plan showing the forecast account movement for that day. The planned
movement is the basis for that day’s money market transactions.
–– Concentration of surplus cash balances, which enables treasury to net surplus funds
with deficiencies, and undertake a single net money market transaction. There are many
systems available to accomplish this process, from automatic bank ‘sweep’ accounts to
electronic funds transfers.

3. Intercompany flows
Many organisations have significant inter-company transactions which require the flow of
funds from one business unit in the group to another. These flows need to be centralised
through the treasury and isolated from the external funding flows. This enables treasury to
settle the transaction in a coordinated manner, netting the payments off against each other.
The settlement can often be accomplished without a physical cash payment through the
recording of journal entries in the respective business unit’s treasury loan account. Where the
transaction involves the payment of foreign currency to a business unit in another country,
treasury is able to match/net the currency position of both subsidiaries.

4. Investment of surplus funds

Safeguarding the organisation’s cash balances is fundamental to an organisation. Investments
must only be made to the credit approved organisations listed in the company’s authorised
investment list. This activity can be controlled by centralising the investment of surplus funds
with treasury.

The maximisation of return earned on the funds invested is a secondary objective. Market
information systems, such as Reuters, and competitive quotes should be used to ensure that
the highest possible return is made commensurate with acceptable levels of risk.
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The investment of surplus funds must meet the organisation’s liquidity objectives and be
consistent with the current cash forecast. Where cash forecasts are unreliable, there will
be a tendency for a conservative investment strategy to be adopted. Funds are likely to
be invested in at-call deposits, normally resulting in lower returns than those obtainable
from longer-term investments—except in periods of market stress, such as in 2008–11,
following the commencement of the GFC.

5. Performance measures
Management’s performance is normally strongly influenced by, and biased towards,
the measures on which it is to be appraised. Where these performance measures do not
include a benefit (or penalty) for the efficient (or inefficient) use of cash resources, it will
normally lead to a lack of resolve—and control—in the area, which may not be detected

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until it becomes a critical issue. Cash-based performance measures must be taken seriously
and, equally importantly, must apply to all managers who have a significant impact on the
company’s cash cycle.

The cash generated by a business unit is the simplest performance measure which can be
used. The measure is simple and intuitively unambiguous. It is easy to measure and assess,
and is directly related to the overall group objective of cash maximisation.

Cash disbursements
Cash disbursements are the outgoings of cash from an organisation. As far as cash management
is concerned, the objective of a cash disbursement policy is twofold. It seeks to ensure that cash is
disbursed on a timely basis to the correct creditor and, importantly, that the appropriate controls
are in place to mitigate any potential fraud by employees. The aim of this twofold objective is to
maximise the cash balances and safeguard an organisation’s most liquid asset—cash.

Organisations with well-developed cash disbursement policies maximise the amount of time
taken for payments to be made and cash to be drawn from their bank accounts.

Some procedures to achieve the objectives noted above include, but are not limited to,
the following:
• Proper authorisation of transactions. Invoices or supporting documents should be
provided prior to signing a cheque or processing an electronic payment.
• Segregation of duties. Approval of disbursements should be separate from preparation
of the payment transaction and purchasing functions.
• Design and use of adequate documents and records. This may involve using pre-
numbered cheques printed directly from the organisation’s electronic accounting software
or reconcilable electronic funds transfer summaries of electronic payments to be made.
• Access to assets and records. Access to and usage of cheque-signing machines and
signature plates should be controlled.
• Independent checks. Signed cheques and electronic funds transfer (EFT) payment
confirmations should be checked against payment summaries to ensure veracity. Failures in
this area often allow fraud to remain undetected for considerable periods.
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Free cash flow

Organisations report their earnings on an accrual basis. However, this does not take into
consideration the cash effect of those earnings on the organisation. The need for free cash
flow analysis arises from differences in timing between recognising income and expenses and
receiving and paying cash, and recording non-cash expenses such as depreciation.

Free cash flow is a company’s operating cash flow after investment in new capital and before the
effects of any new debt. Free cash flow represents the after-tax cash flows available to equity
holders (assuming no debt) and is based on the internal generation of cash (i.e. not from debt or
equity). Copeland and Koller et al. (1996) define free cash flow as follows:
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Free cash flow is a company’s true operating cash flow. It is the after-tax cash flow generated by the
company and available to all providers of the company’s capital, both creditors and shareholders.
It can be thought of as the after-tax cash flows that would be available to the company’s
shareholders if the company had no debt.

Free cash flow relies on the notion that invested capital is the foundation of long-term growth
and productive fixed assets are at the core of a company’s productive ability. This affects the
volume and quality of products or services available to be sold by the company. This is ultimately
related to sales revenue and the capability of the company to achieve growth.

The three core sources of funding or finance are internal cash flow, debt or equity. Free cash flow
is a measure of cash remaining, assuming that new investment capital has come from internal
cash flow rather than additional debt or equity.

To calculate free cash flow, there are three steps. First, depreciation and amortisation charges are
added to net income in order to exclude the funding of transactions that occurred prior to the
current accounting or budget period. Second, the changes in net working capital are subtracted.
Finally, capital expenditures, such as on plant and equipment, are removed. In summary:

Free cash flow = Net income + Depreciation and amortisation –

Changes in net working capital – Capital expenditure

Depreciation and amortisation are added back as we are calculating the free ‘cash flow’, and
depreciation and amortisation are non-cash expenses. While depreciation and amortisation are
recognised in the current period, the outflow of cash for the assets to which they relate occurred
in the past and is not relevant to the current free cash flow calculation.

Note that in the above calculations, the net working capital in a year t (NWCt ) is defined as:

NWCt = Current assets (year t) – Current liabilities (year t)

So, to get the free cash flow in year t, subtract the changes in net working capital in year t,
which is:

NWCt – NWCt – 1

We deduct changes in net working capital as it assumes that this increase relates to the growth
of the company (e.g. higher receivables and inventory balances) and therefore more cash will be
required in the organisation to fund this growth.
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Stress testing
Stress testing, as discussed earlier, refers to an examination of how a company’s finances respond
to an extreme scenario—a form of ‘what if’ analysis companies need to undertake to determine
their vulnerability to breaching various benchmarks, including covenants imposed by lenders.

Stress testing includes scenario analysis, particularly in the wake of the GFC, when it quickly
became clear that something had gone badly wrong with the authorities’ stress testing of major
banks, because virtually all banks passed the theoretical (but not practical) tests.

This also applies to financial institutions, especially since the GFC. While they had been
monitored for various risks—operational, market, and credit, as well as sensitivity analysis—

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to determine how much capital they should hold, many of them seriously underestimated the
risks of over-extended credit when highly-leveraged borrowers were unable to repay their
borrowings and requested extensions—including many sovereign borrowers. One such financial
institution was Northern Rock—as discussed in Module 1.

All banks are subjected to stress testing of some sort. In the US, the Dodd-Frank Wall Street
Reform and Consumer Protection Act requires that the Federal Reserve establish prudential
standards for a large number of banks and various quasi-banks, including liquidity requirements,
overall risk management requirements and a requirement to conduct annual stress tests. In the
UK banks are subject to stress testing against three scenarios—recession, severe double-dip
recession and prolonged downturn.

In fact, in 2012–13 these solvency tests appeared to confirm that banks had sufficiently solid
capital buffers to be resilient against severe stresses, but this assumed that the 1 to 5 per cent
extreme risk would not occur—such as the collapse of the eurozone.

For companies, stress testing is designed not simply to monitor ratios such as working capital,
but to examine the ability to meet unexpected but potential events. The issues to avoid include:
• margin erosion: ratio of sales to expenses falls (gross profit ratio);
• high gearing: over-leverage of debt or erosion of equity base;
• under capitalisation: insufficient equity;
• lack of cash flow forecasting; and
• trouble meeting cash obligations such as the goods and services tax (GST) and pay as you go
(PAYG) obligations.

Key questions that need to be considered include:

• What is the break-even level for the business? All companies need to specify this key level
in writing.
• What is the impact on revenue and earnings if you lose 10 per cent of sales or a major client?
• How is average receivable days outstanding tracking (i.e. to what extent are you effectively
paying your customers’ working capital costs)?
• What would trigger a staff cut (e.g. revenue falls below $10 000 per employee per month)
and do you have the required cash flow to fund redundancies?
• What overheads will you reduce and what measures will you take to preserve cash?
• What non-core assets could be sold to reduce debt and provide additional cash flow?
• What do you have to do to meet tax office requirements?

The board of directors should have a clear idea of the key sensitivities and put contingency
plans in place before they are needed. Proactive risk management rather than reactive risk
management is essential in this area.
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Part B: Working capital management

Working capital comprises an organisation’s current assets and current liabilities. Working capital
management relates to the methods that an organisation employs to invest in its current asset
base and where it sources short-term financing needs (i.e. its current liabilities). The aim of
managing working capital is to maximise the value of an organisation’s short-term capital.

Strategies to manage working capital

An organisation can employ a number of strategies to help maximise its working capital position.
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These strategies revolve around the organisation holding onto cash for the greatest amount of
time so that the value of the organisation is maximised. Virtually all statement of financial position
items can have the timings of their cash flows adjusted—for a price.

A good starting point in effective working capital management is to ensure that internal reports
on income, the statement of financial position and actual cash flow results are reviewed regularly
and compared to budgeted outcomes to ensure that the key users of working capital (i.e. stocks
and debtors) are performing to plan. The cash flow forecast is critical and acts as an early warning
system to monitor and ensure a business has, and will have, adequate working capital resources
to fund its operations. It is also a key document required for external stakeholders such as banks
and creditors.

In addition to the internal strategies just discussed, external factors such as interest rates and the
cost of credit, exchange rates, average debtor days, material and labour costs and other cash
utilising items should be examined for consistency. Once the effective and continual monitoring
of a cash flow system has been established, the strategies to manage these cash flows can be
designed and executed.

As mentioned, the management of working capital has the fundamental objective of enabling
the company to hold onto cash as long as is commercially acceptable and to defer the payment
of expenses for as long as is commercially viable. Management of working capital also involves
using methods such as discounts for immediate or cash payments or factoring for converting
revenues as quickly as possible into cash holdings. Some of the strategies that achieve these
working capital goals are outlined in Table 2.1.
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Table 2.1: Working capital management and the statement of financial position

Area Cash value Alternative Tax effects In-house strategies

(A) Assets

Debtors Factoring: cash Securitise if Review credit terms

benefit up-front large amounts Benchmark: days
(thus converting outstanding
Alternative: trade receivables
finance immediately
into cash)

Motor vehicles Lease Loss of Comparing cost of asset

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depreciation funding using the two
Sale and matched by techniques
leaseback lease payments

Plant and Lease or rent Project financing Comparing cost of asset

equipment (most applicable funding using the two
for larger-scale techniques
asset-based
funding)

Inventory Inventory Revise delivery Various stock turnover ratios,

management terms to buyers including those affected
systems (if commercially by sales
feasible)

(B) Liabilities

Creditors Reschedule Refinance or Review supplier

‘Manage the seek suppliers payment terms
float’—gapping who give more Benchmark: days
between generous outstanding and as a
receivables payment terms comparison to industry
and payables practice

Borrowings Equity versus Bill facility Borrowing costs The company’s after-tax
borrowings Swap programs are usually weighted average cost
deductible, of capital.
while equity
raisings are not Any minimum targeted
returns on equity (which
may constrain the amount
of equity to be considered
for raising)

Statement of financial position relevance to cash management:

Stocks versus flows
A statement of financial position is a snapshot of a company on a particular day. All assets and
liabilities are simply aggregated cash flows. For example, a motor vehicle can be seen either as a
stock (purchased outright) or a flow (sale and leaseback).

Therefore every cash flow management review or audit should also examine the statement
of financial position, as is illustrated in Table 2.1 above. For example, a fleet of vehicles could
be sold to a financier and the cars then leased back—thereby freeing up the capital tied up in
ownership of the vehicles.
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It is essential not to confuse cash flow management with profit and loss management. While the
two are related, they are very different in their goals. Many profitable companies go into
receivership because of cash flow problems, whereas companies frequently make losses on
profit and loss account without seriously impairing their short- or long-term viability.

Other methods of adjusting cash flows include:

• Negotiate trading terms with creditors so that payment for goods and services purchased can
be deferred for as long as possible.
• Collect receivables in the shortest time possible. This may include offering payment options
such as EFT, BPay, credit card facilities, direct debit or imposing additional charges for late
payments. Outsourcing of debt collection is also a way of decreasing the time taken to
collect receivables.
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• Turn over inventory in the shortest possible time. For manufacturers, inventories represent a
large investment that does not earn interest. Employing better-practice inventory ordering,
storage and delivery methods keeps the level of inventories to a minimum, and working
capital used to its lowest practicable level.
• Enable work-in-process to be completed in the shortest amount of time. Work-in-process
comprises those items of inventory currently being manufactured that have not yet been
finished. This strain on capital can be reduced through greater processing efficiencies.

Factoring
Factoring is the sale of an organisation’s accounts receivable (i.e. debtors) to an external party
(the factorer) at a discount to their face value. It is also known as cash flow financing or accounts
receivable financing, and is a long-established method of improving an organisation’s working
capital management.

This strategy enables the organisation to receive cash up-front from the factorer, rather than
waiting for customers to pay the amounts due. For example, if the accounts receivable was
$500 000, the factorer may ‘buy’ the debt for $450 000. The organisation forgoes $50 000,
but receives the $450 000 immediately. In general, factoring improves collection of debtors,
bringing forward cash inflow into the organisation so that it can better meet cash outflows.
This can be measured by a reduction in the accounts receivable period.

Factoring gained popularity in the early 1900s, particularly in the US textiles industry where
the inventories held and work-in-process periods were significantly longer than they are today.
Factoring has proved popular during times of high interest rates (e.g. in the mid-1970s) and
during times of tightened banking regulation (e.g. in the 1980s following the US savings and loan
crisis) where this type of finance was seen as relatively low cost and requiring less documentation
compared to traditional banking facilities such as an overdraft.

Two types of factoring are commonly used—full recourse and non-recourse factoring.

Full-recourse factoring occurs where the factorer pays the organisation immediately for a
portion of accounts receivable rendered. In return, the factorer assumes the credit risk of the
debtors accounts and receives cash as the debtors settle their accounts up to the point where
the credit terms provided by the organisation are exceeded. After this time, the outstanding
accounts’ debtors are sold back to the organisation. This benefits the organisation by bringing
forward cash payments to the point that accounts are raised rather than having payments made
according to the terms given to customers. In summary, the factorer does not take on the risk
associated with bad debts (i.e. when the credit terms expire, the factored sells the debt back to
the company).
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Non-recourse factoring applies mainly to large invoices where an organisation has a large
exposure to one organisation. Here, the company sells a large debtor account to a factorer at
a significant discount to face value. This discount compensates for the fact that the title of the
account’s debtor passes to the factorer. The factorer bears the credit and default risk of the
debt so that if the debt is unable to be recovered, the cost of that debt lies with the factorer.
While non-recourse factoring is more risky for the factorer, it is compensated by a higher yield
received on the debt. In summary, the factorer takes on the credit risk associated with bad debts.

The main advantages of factoring are as follows:

• Factoring allows the selling company to bring forward cash receipts. This reduces adverse
cash flow effects on the company.
• Outsourcing the collection of debtors to a factoring company allows a company to focus

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on its core competency. This is particularly true of small or micro enterprises where limited
resources exist which cannot afford to be diverted away from the operations of the business.

The main disadvantages of factoring are as follows:

• The factorer purchases debtor accounts at a discount to their face value. This can
disadvantage the business if the cost of the discount outweighs the benefit gained by
bringing forward cash inflows.
• One risk of factoring is that it can create a negative impression with the company’s debtors
whose accounts have been factored. Factoring should be implemented in a way that
is seamless to customers, especially where the business provides confidential services.
In general, factoring is less risky to implement in business-to business markets.

Measuring working capital requirements

By using current or forecast financial information, an understanding of trends and cash flow
cyclicality within an organisation and cash flow implications of future growth can be obtained.
These measures enable the organisation to acquire the appropriate level of working capital
now and in the future. The main components of working capital are cash, inventory (or work-in-
process), accounts receivable and accounts payable. Any increase in net working capital reduces
the free cash flow that is available to the company. Since the value of the company is the present
value of these free cash flows, changes in net working capital directly affect company value and
need to be actively managed.

The working capital performance of a company can be established using ratios calculated from
these cycles. Working capital ratios can be compared within a company over time or between
companies in the same industry to achieve optimum targets. Figure 2.1 shows the typical cash
and operating cycles for an organisation.

An organisation’s operating cycle is the average time from when the organisation purchases
its inventory to when it receives cash from the sale of its product. The organisation’s cash cycle
is the average time from when the organisation pays for its inventory to when it receives cash
from the sale of its product. Note that if an organisation pays cash for its inventory the operating
and cash cycles will be the same. However, an organisation will usually purchase inventory on
credit creating an accounts payable which reduces the time between the cash paid out and
cash received.
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Figure 2.1: Cash and operating cycles for a company

Company buys Company pays Company sells Company
inventory for inventory product receives payment

Inventory Accounts receivable

Accounts payable

Cash outflow Cash inflow

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Cash cycle

Operating cycle

To assist in determining working capital requirements, finance managers can compute the
cash conversion cycle which is the time between paying for inventory and collecting on
receivables, computed as:

Cash conversion cycle = Work-in-process (or inventory) period +

Accounts receivable period – Accounts payable period

where:
Work-in-process (or inventory) period = Inventory / Average daily cost of goods sold
Accounts payable period = Accounts payable / Average daily cost of goods sold
Accounts receivable period = Accounts receivable / Average daily sales

Note that the average daily cost of goods sold and average daily sales are defined respectively as:
Average daily cost of goods sold = Cost of goods sold / 365
Average daily sales = Total sales / 365

Example 2.2 illustrates the calculation of an organisation’s cash conversion cycle.

Example 2.2
The following information has been obtained from the financial statements of a large Australian mining
company. The numbers are in millions of US dollars. Compute the work-in-process (or inventory),
accounts receivable and accounts payable periods for the company as well as its cash conversion
cycle and comment on your findings.

30 June 20X3 30 June 20X2 30 June 20X1

Total sales revenue $50 800 $60 122 $48 076
Cost of goods sold $21 737 $29 473 $21 315

Accounts receivables $5 577 $9 801 $4 689
Inventory $5 034 $4 971 $3 296
Accounts payable $7 550 $8 796 $6 826
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Solution
The average daily cost of goods sold and average daily sales for 20X1 can be computed as follows:

Average daily cost of goods sold (20X1) = 21 315 / 365 = $58.40

Average daily sales (20X1) = 48 076 / 365 = $131.72

The work-in-process, accounts payable and accounts receivable periods are:

Work-in-process (or inventory) period = 3296 / 58.40 = 56.44 days

Accounts payable period = 6826 / 58.40 = 116.88 days

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Accounts receivable period = 4689 / 131.72 = 35.60 days

The cash conversion cycle is:

Cash conversion cycle = 56.44 + 35.60 – 116.88 = –24.84 days

Similarly, we can compute the cash conversion cycles for 20X2 and 20X3.

30 June 20X3 30 June 20X2 30 June 20X1

Average daily sales $139.18 $164.72 $131.72
Average daily COGS $59.55 $80.75 $58.40

Inventory period 84.53 61.56 56.44
Accounts receivable period 40.07 59.50 35.60
Accounts payable period 126.78 108.93 116.89

Cash conversion cycle –2.18 12.13 –24.84

In 20X1, the company’s cash conversion cycle was negative, implying that it was able to receive cash
for its products before it paid its suppliers. As a result of its accounts receivable period increasing by
almost 70 per cent, in 20X2 the company’s cash conversion cycle was 12.13 days. By 20X3, its cash
conversion cycle was again negative due to a drop in its accounts receivable period as well as a
simultaneous rise in both the inventory and accounts payable periods.

Example 2.2 also illustrates that while the finance manager may focus on the cash conversion
cycle to assess how efficiently an organisation is using its working capital, it is important not
to lose sight of the individual components of the cash conversion cycle. For example, an increase
in the accounts receivable period may indicate that an organisation is facing problems collecting
cash from its customers while a decrease in the accounts payable period may indicate that
the organisation is not taking full advantage of opportunities to delay payments to its
suppliers. An increase in the inventory period may indicate the ineffective management of
the organisation’s inventory.

As mentioned above, any increase (or decrease) in net working capital reduces (or raises) the free
cash flow that is available to the organisation. Since the value of the organisation is the present
value of these free cash flows, changes in net working capital directly affect organisational value
and so it needs to be actively managed. The relationship between net working capital and free
cash flows is illustrated in Example 2.3.
 106 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Example 2.3
The following information relates to PTP Ltd’s projected net income, depreciation and amortisation,
capital expenditure and change in net working capital for the coming financial year.

Net income $20 000 000

Depreciation and amortisation $5 000 000
Capital expenditure $5 000 000
Increase in net working capital $2 000 000

Estimate the organisation’s expected free cash flows in the coming year.

Management expects capital expenditure and depreciation and amortisation to continue to offset
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each other in the foreseeable future. Management also expects net income to remain unchanged in
the foreseeable future. Assume that PTP Ltd is able to reduce its annual increase in net working capital
by 20 per cent by managing its working capital more efficiently without adversely affecting any other
part of its business. How would this change the organisation’s free cash flows? How does your answer
change if the organisation is able to reduce its annual increase in working capital by 30 per cent?

Solution
The organisation’s free cash flows for the next year are:

Net income $20 000 000

Plus Depreciation and amortisation +$5 000 000
Less Capital expenditure –$5 000 000
Less Increase in net working capital –$2 000 000
Equals Free cash flow $18 000 000

A 20 per cent reduction in the increase in its net working capital would change the increase in net
working capital from $2 000 000 to $1 600 000. This implies a free cash flow of $18 400 000 or an increase
in free cash flows of $400 000 per year. Similarly, a 30 per cent reduction in the increase in its working
capital would change the increase in net working capital from $2 000 000 to $1 400 000 which would
result in the free cash flows increasing by $600 000 per year.

➤➤Question 2.1
Widgets & More Pty Ltd is a small, private company based in Melbourne. Over the past three
years the company has been experiencing steady growth in sales. However, because of its size,
the company’s access to funds is limited to a line of credit with its bank. The company wishes to
expand its inventory while maintaining a current ratio of at least 2.5. The company’s current assets
are $5 250 000 and its current ratio is 3.5. How much can the company expand its inventory base
before it reaches its targeted current ratio?

➤➤Question 2.2
Refer to the statement of financial position in Example 2.1 and to the profit and loss statement
below. Both are for Herb Ltd and Shrub Ltd at 30 June 20X5.
Herb Ltd Shrub Ltd
($000) ($000)
Total sales 120.0 150.0
Cost of goods sold 80.4 127.5
Gross profit 39.6 22.5
Selling and distribution expenses 10.0 5.5
General and administration expenses 4.0 2.3
Operating profit 25.6 14.7
Interest expenses 5.0 3.0
Net profit before tax 20.6 11.7
Income tax expense 6.2 3.5
Net profit after tax 14.4 8.2
Compute the accounts receivable and payable periods for both companies and comment on
the results.
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Credit risk assessment

Funding risk is the probability that an organisation will be unable to meet its obligations due to
failings in the stock or flow aspects of funding—that is, capital risk and liquidity risk, respectively.

Capital risk is the danger that an organisation has insufficient capital (debt + equity) to achieve
required capital ratios (perhaps thereby breaching borrowing covenants) or to support business
operations.

Liquidity risk is breaching liquidity covenants or the inability to meet obligations in a timely
manner.

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This section examines the nature of this funding risk from a lender’s perspective and how to
manage it. The section also addresses the drivers, key metrics and methodology to measure
and monitor risk issues relating to funding. It concludes with an example of the actual evaluation
of a major loan to a company.

From a lender’s perspective, credit risk arises from the lending or provision of money to an
organisation. Funding risk from the lender’s perspective is the risk that an organisation to which
it has lent funds, is unable to meet its obligations. This is different (or the opposite) to funding
risk from an organisation’s perspective, which is the risk that the institution providing funds
(e.g. a bank) will cut or stop its supply of funds (e.g. bank overdraft).

This information is of considerable importance to all borrowers as the issues raised below are the
ones that borrowers need to address if they want to be able to borrow.

Nature and measurement of credit risk

There are two quite different views of funding risk—one from the perspective of the borrower or
shareholder, which focuses on the profitability of funding an operation or project, and the other
from the perspective of the lender, which emphasises the timely servicing of the loan, including
the repayment of the principal. The latter is called credit risk and is the overarching risk that is the
focus of lender’s assessments of a loan’s commercial viability.

From the lender’s point of view, it is necessary to undertake a credit risk assessment before any
loan can be made. The assessment is a process of analysing both qualitative and quantitative
elements of the loan’s proposal to see if it satisfies the criteria of the lender. The qualitative
assessment is designed to assess the lending history, integrity and experience of the borrower,
and will include skills and competency assessments of not just directors of the board, but also
of the company’s senior managers (this is particularly so of privately owned enterprises).
The qualitative assessments may extend to not just internal but also external factors that may
affect a business’s ability to repay any loan, such as the industry, the geographic location or
the nature of the loan.

Qualitative assessments of credit risk and loans are often defined by the credit policy or the
financial institution’s general lending guidance criteria. These criteria reflect the nature of the
lender’s own business which stipulates the nature of how loans are advanced to given borrowers
and under what circumstances. For instance, some lenders will not advance credit to certain
hostile acquisitions or casinos.

If a loan proposal meets the general policy criteria of a lender, the second and more quantitative
element of a loan proposal will need to be analysed and satisfied. This centres around the risks
associated with the loan and the probability of that loan being repaid together with interest.
This assessment involves the skills of the lending institution and the company wanting to borrow
justifying its case for the borrowing, and demonstrating that it will be able to repay the debt and
interest as and when it will fall due.
 108 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Often lenders, like financial analysts, will assess a company using financial ratios to determine
the financial robustness of a borrower’s statement of financial position and cash flows. Key ratios
include the interest cover ratio, the company’s free cash flow, quick ratio and debt to equity ratio.

However, by far the most important ratios from a lender or credit assessor’s point of view are
those relating to the company’s ability to generate and pay cash to fund interest rate and capital
repayment obligations. For example:
• The ‘free cash flow’ metric literally describes the amount of cash generated by a company’s
operations.
• The quick ratio alternatively shows the company’s ratio of current non-inventory items that
can be turned into cash immediately to pay off all current liabilities ‘quickly’.
• The debt to equity ratio shows the extent of debt relative to the owner’s own capital
MODULE 2

commitment to a business.

These ratios are important quantitative risk measures that are routinely used by rating agencies
(whose ratings or analysis we discuss below) in calibrating the relative ‘risk’ of a business’s ability
to pay its debt obligations as and when they fall due. These rating measures of risk are then
used in turn by lenders in charging the appropriate interest rate risk margin or fee for a given
loan. The ratings not only define the cost of credit to a business, but implicitly set quantitative
limits that lenders will give a company that also seeks to maintain its credit rating. For example,
if a company borrows beyond a certain amount or debt ratio range (as measured, for instance,
by the debt to equity ratios), it could push its rating to a lower rating/higher risk part of the
rating matrix, in turn raising its credit costs. Ratings therefore act as a constraint on a board’s
risk appetite and, for that reason, companies routinely have among other performance metrics a
‘target’ credit rating to ensure their own cost of funding is managed.

Even if a company has had an excellent history of repaying loans and qualitatively meets a
lender’s competency tests for borrowers, a finance manager will still need to provide evidence
of the future prospects of generating sufficient free cash flow to service both its existing loan
obligations and proposed obligations for the life of any new loan, together with an agreed loan
amortisation schedule. In this, cash flow forecasts and plans are critical and are evidence of the
serviceability of a loan, preferably if the revenue is from the ordinary business operations.

Thus, the ability of a company to access finance is not just based on its internal operational
efficiency, but also on its ability to manage its financing and credit risk. In addition the company
needs to be able to pass stress testing criteria. Evidence is provided by robustly integrated cash
flow management and funding processes and controls that are aligned to the strategic plan of
the company.

Financiers’ lending decisions

Financiers have two primary considerations when lending:
1. return: the anticipated commercial return on the loan; and
2. risk: the extent to which the shareholders’ funds are in jeopardy. This is broken into two
further categories:
(a) probability of default: how likely it is that the borrower will be unable to meet all debt
servicing requirements as well as other undertakings (such as a minimum quick asset
ratio); and
(b) loss given default: how much of the loan and liabilities are likely to be required to be
written off (the NPV of the loan, given default).
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The key nature of counterparty risk (probability of default)

Below is a simple example of the critical nature of counterparty risk.

Consider the situation where a bank borrows $10 000 000 at 5 per cent and lends $1 000 000
to each of ten counterparties at 15 per cent (a margin of 1000 basis points).

Nine repay: Bank receives $9 000 000 principal plus $1 350 000 interest = $10 350 000

One defaults: Bank still has to repay $10 000 000 plus $500 000 interest = $10 500 000

Overall loss: = $150 000

MODULE 2
The key to successful lending is not so much maximising the margin as minimising default.
As a result, banks place great emphasis on protecting their principal at risk. In this example,
10 per cent (being the difference between the borrowing and funding rates) was used for
illustrative purposes only. In practice, the probability of loss of principal is far lower—in the
case of normal long-term loans to A‑rated companies, as assessed by Standard & Poor’s (S&P),
the probability is less than 0.04 per cent.

However, it is the conditions surrounding this particular transaction that make the assessed risk
far greater than would normally be the case. Each transaction is examined by a bank on its own
merits to determine whether it will be approved in the first place and, if so, under what terms
and conditions.

Risk and return are always examined together. They are often depicted graphically as a trade-off:
the higher the expected return, normally the higher the implied risk (as shown on the standard
‘x’ and ‘y’ axes of a simple graph).

With respect to return, normally margins between borrowing and lending costs are adjusted
for risk (via the establishment of various reserves, such as counterparty risk, liquidity risk,
administrative expenses reserves and so on), then benchmarked against the capital at risk with
respect to the loan.

The second and interconnected issue is the risk to the lender of the loss of shareholders’ funds
through the failure to repay interest and/or principal in a timely manner. The financier’s main
concern is that the borrower will generate sufficient cash flow to enable it to pay interest and
make scheduled principal repayments. If it fails to do this, it defaults.

The implication for companies that wish to borrow is that for those companies with riskier or
more cyclical revenue and cash flows, financial institutions (seeking as they do to minimise the
risk of loan default) will routinely require a higher level of equity in a business as opposed to
more stable, less cyclical, predictable (and probably more regulated) cash flows. In this way,
the financial institution requires the equity owners to provide a larger buffer of capital support
to the business in view of the greater probability of a shortfall in cash flow.

The above is particularly true of start-up or emerging industries where revenues are not so
assured or definitive. The converse is also true, that is, that mature, well-experienced and stable
cash flow businesses tend to have better access to loan capital and in larger quantities relative
to their equity capital bases. They tend to be more leveraged as well, displaying as it does the
banks’ and other lenders’ level of comfort with their underlying cash flows and capacity to pay.
 110 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Bank loan assessment and management

This section provides an example of a loan from an Australian bank to a large Australian corporate.

Overview of loan assessment

A normal commercial loan assessment approval process by an arm’s length lender involves a
series of risk identification and mitigation steps prior to any loan being approved. Margins and
conditions are then set, followed by a monitoring and management process during the life of the
loan or facility.

Megabank is arranging a funding package for Forest Ltd, for facilities totalling AUD 500 million.
MODULE 2

In arriving at an initial benchmark for Forest Ltd, Megabank has relied in part on the group’s
credit rating from Standard & Poor’s (S&P).

The matrix in Table 2.2 is from the terms of the loan (facility) agreed to by Megabank and
Forest Ltd.

Table 2.2: Megabank margins charged against S&P ratings

S&P group rating for Line fee Commitment fee

Forest Ltd Margin (over $200m) % p.a. (under $200m) % p.a.

A– or higher 0.10 0.30 0.20

BBB+ 0.10 0.35 0.25

BBB 0.20 0.425 0.25

BBB– or below Do not lend Do not lend Do not lend

Megabank sets the cost of borrowing by Forest Ltd by adding a margin to the base rate, which is
stated in the agreement to normally be the bank bill swap rate (BBSW).

The total margin charged depends on S&P’s long-term rating for Forest Ltd plus other factors
relating to the total amount borrowed and the timeliness of payments. However, it is the overall
importance of the rating itself that is the key, as that rating is based on an analysis of financial
ratios and asset quality designed to determine Forest Ltd’s probability of default (POD) and the
consequent loss given default (LGD). S&P’s analysis encompasses the consideration of factors
such as gearing ratios, the level of net assets and free cash flow.

Megabank/Forest Ltd loan: Overview of loan assessment

To illustrate the analysis, systems and controls behind a bank’s decision to lend to a company
and the terms and conditions attached to that decision, this section examines Megabank’s
loan documentation.

The sections in the memorandum are:

• purpose of loan: must meet lender’s criteria;
• management/management information systems: a test of the ability of the borrower to
monitor the loan and its own operations;
• debt servicing/sensitivity: ability to withstand business cycles or shocks, such as interest
rate spikes;
• cash flow forecast (a key document);
 Study guide | 111

• customer rating—system and risk profile: often relies on external ratings;

• business risks;
• quality of securities;
• conditions precedent: these may be added—often in the form of embedded options,
such as the ability to call the loan early;
• covenants/ratios disciplines: controls and monitoring metrics;
• exit analysis (the bank’s primary and secondary exits): see below;
• pricing—profitability for the bank;
• share/stock price and rating agency comments;
• local issues;
• date of drawdown and term; and
• sign-off (is the loan recommended/not recommended?).

MODULE 2
The memorandum describing the facility
Typically, a loan agreement would address the following—assuming, for the purposes of this
exercise, that an AUD 500 million loan has been approved in principle.

Facility AUD 500 million five-year term loan

Guarantor Forest Holdings Group

Purpose To finance the farming of giant forests in Tasmania, Australia

Coordinating arranger Megabank

Facility Term loan facility. The facility will be structured as a loan note
facility so as to be eligible for Australian withholding tax
exemption under section 128F of the Income Tax Assessment
Act 1997 (Cwlth)

Final maturity Five years from drawdown

Facility amount AUD 500 million

Repayment Bullet on final maturity

Up-front fees 45 basis points (bp) flat

Financial covenants Covenants consistent with current terms and conditions

currently applicable for the guarantor on existing corporate
debt facilities

Adjusted consolidated tangible net worth Not less than AUD 1 billion

Consolidated borrowing Not to exceed twice the adjusted consolidated net worth

Secured consolidated borrowings Not to exceed adjusted consolidated net worth

Other covenants The borrower (Forest Ltd) shall remain a wholly owned
subsidiary of the guarantor (Forest Holdings Group)

Limited negative pledge for both

borrower and the guarantor

Guarantor to maintain at least 35 per cent

direct or indirect ownership of Forest Ltd
 112 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Exit strategies
Exit strategies for Megabank are also covered:
• Primary exit (primary source of repayment, or PSOR): cash generated by parent guarantor
in the normal course of business.
• Alternative PSOR primary exit: sale of Forest Ltd or the forests.
• Secondary source of repayment (SSOR) or secondary exit: refinancing by banks at group level.
• Alternative SSOR (secondary exit): sell-down of the debt by Megabank in the secondary
market.

Overall, the key for the bank is to make a profit on its loan, which absolutely requires return of the
principal and the timely servicing of the debt.
MODULE 2

Summary
An organisation’s ability to access funding and liquidity is based on the financier’s qualitative and
quantitative assessment of the organisation’s ability to manage its credit risks and to be able to
meet stress criteria. For finance managers, a better appreciation of the processes, requirements
and lending criteria that finance providers operate to, will assist a business’s ability to strategically
plan and manage any challenges of funding. It will also assist a business in effectively engaging
with its lending partners.

➤➤Question 2.3
Referring to the memorandum describing the AUD 500 million facility for Forest Ltd by Megabank,
what three key terms or conditions have been omitted from the memorandum?

➤➤Question 2.4
Hyperactive Ltd, an Australian personal fitness group, has approached Megabank for a three‑year
loan of $2 000 000. Hyperactive has a current history of being in business for three years,
with share capital of $1 000 000 and $200 000 profits per annum in each of those three years.
It has a rating of BBB– and no other borrowings.
Would Megabank be likely to lend to Hyperactive, given their approach to lending as outlined
above? Why?
 Study guide | 113

Part C: Sources of funds for business

Short-term financing refers to financing arrangements that have a maturity of less than one year,
while maturities of between one and five years are often described as intermediate-term finance.
However, these classifications are arbitrary and should not be taken too literally. For example,
bank overdrafts are usually classified as short-term funding but, in practice, tend to be regarded
as a permanent source of funding. This section identifies the major types of such financing
instruments and outlines the principal advantages and disadvantages of each.

Money market instruments

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Money market instruments are short-term debt instruments that are traded in the money market.
Their maturity is less than one year, and usually less than six months. They pay a pre-specified
amount at maturity (i.e. the face value) and make no intermediate interest payments.

Bills of exchange and bank bills

Bills of exchange have been used for centuries, mainly to finance international trade. The early
London-based merchant banks promoted their use by discounting bills drawn by a seller and
accepted as evidence of debt by a buyer. The Bills of Exchange Act 1909 (Cwlth) defines a bill of
exchange as:
An unconditional order in writing, addressed by one person to another, signed by the person giving
it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable
future time, a sum certain in money to, or to the order of, a specified person or bearer.

The simplest form of a bill of exchange exists where an organisation requires funds on a short-
term basis, draws up a bill requiring that payment will be made by the party to whom it is
addressed. That party, the acceptor, on signing the bill, promises to pay the sum of money
nominated in the bill (usually a multiple of $100 000) on a fixed date. A discounter will initially
lend the funds and has the choice of either holding the bill to maturity or trading the bill on a
discount basis. It should be noted that an acceptor can act as discounter.

Bills of exchange can be either trade bills or accommodation bills. Trade bills are created to
finance a specific trade transaction, whereas accommodation bills have no underlying transaction
but are primarily a means of financing working capital. Accommodation bills are usually issued in
standard amounts to facilitate marketability and rolled over to extend the financing term.

A bank bill is a bill of exchange where a bank takes the credit risk on behalf of a third party, which
makes the instrument more acceptable to investors. Banks charge an acceptance fee for this
service. In addition, an establishment or facility fee may be charged by the financial institution
which arranged the issue along with a regular maintenance fee.

Bank bill financing is an alternative to the normally more expensive bank overdraft financing.
From the lender’s point of view, it allows a much greater degree of flexibility in the funding
arrangements in that, at any time, the bank can sell that bill in the market. Hence, the bank does
not have the funding commitment, although it does take the credit risk on the amount of the bill.

Because of the high credit standing of banks, the interest cost on bank bills is generally lower
than other alternative sources of short-term finance. However, this is offset to some extent by the
fact that an acceptance fee is payable by the borrower to the acceptor.
 114 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Commercial bills of exchange are another form of a bill of exchange where the borrower’s name
in the marketplace is strong enough to stand on its own. It is therefore not always necessary or
appropriate to have the bill accepted by a bank. For large, blue-chip companies, bills may be
readily accepted in the marketplace. For other organisations, the issuer of the bills will often
arrange a bill discount facility with a financier, which represents a commitment by the financier
to buy the bills from the borrower on an agreed basis. This, in essence, is a form of underwriting,
and guarantees that the borrower will always be able to convert the bill into cash when required.

To summarise, there are two reasons for drawing bills of exchange:

1. to finance a specific trade transaction (trade bill); and
2. to finance working capital (accommodation bill);
and there are two main types of bills of exchange:
MODULE 2

1. bank bills (where a financial institution such as a bank is the acceptor); and
2. commercial bills (where a bank is not required to act as the acceptor).

Example 2.4 details how a simple trade bill of exchange works in practice.

Example 2.4: Bills of exchange

The following steps and diagram describe a simplified process for a trade bill of exchange.

Step 1: Company X buys merchandise from Company Y for $140 000.

Step 2: Company X (the borrower/drawer) draws a 30-day bill of exchange with a face value of $141 151
and a rate of 10% p.a. (this represents the future value of $140 000 in 30 days’ time).

Step 3: Bank A (the acceptor) guarantees repayment of the bill (charging an additional fee for this role).

Step 4: Bank A (as the discounter) also provides the finance by buying/discounting the bill for $140 000
(i.e. $141 151 / (1 + (30 / 365 x 10%)) = $140 000).

Step 5: Bank A pays $140 000 to Company Y. Note that an alternative is to provide the funds to
Company X (the drawer/borrower), who would then pay Company Y.

Step 6: Company Y would then deliver the merchandise to Company X.

Step 7: At maturity of the bill, Company X repays $141 151 to Bank A.

1. Buys merchandise for $140 000;

2. Draws bill for $141 151

Company X Company Y
6. Delivers merchandise

7. Repays $141 151 5. Pays $140 000

Bank A

3. Accepts bill
4. Discounts bill
 Study guide | 115

Promissory notes (commercial paper)

Promissory notes are negotiable (that is, tradeable) instruments which can be used to create a
debt or secure a debt and, when transferred, give good title to buyers or lenders and so can be
readily converted into cash. The Bills of Exchange Act 1909 (Cwlth) defines a promissory note
as follows:
A promissory note is an unconditional promise in writing made by one person to another, signed
by the maker, engaging to pay, on demand or at a fixed determinable future time a sum certain in
money to, or to the order of a specified person or to bearer.

Since they carry only the name of the issuer (the maker), promissory notes are also known as
one-name paper or commercial paper. A promissory note involves a promise by the issuer or
maker (sometimes referred to as the drawer) to pay monies by one or more instalments to some

MODULE 2
other person, known as the payee (the lender or, for subsequent holders, bearer). The note
must be signed by the issuer, must be for a specific sum of money and must specify the time of
repayment. The note may be held by the payee or transferred to another person who is then
entitled to receive the money promised by the issuer. Notes are issued at a discount to face
value, redeemable at par on maturity. They are normally issued with a maturity of 180 days or
less and are issued in multiples of $100 000. The main advantages of promissory notes are their
flexibility and negotiability.

Unlike bills of exchange, promissory notes do not require the endorsement of a third party when
sold in the market, since they trade on the strength of the name of the issuing company. It follows
that a strong credit rating is required.

Negotiable certificates of deposit

Negotiable certificates of deposit (NCDs) are issued by banks in exchange for a deposit of funds.
The issuing bank agrees to pay the amount deposited ($100 000 or greater) plus interest to the
bearer of the certificate on a specified date. Maturities may range from a few days to a few years,
but most commonly are for 180 days or less. Certificates are traded in the market at rates similar
to bank-accepted bills. They are similar to a one-name paper in that they trade on the reputation
of the issuing bank, which is the only name appearing on the paper.

Money market instruments in practice

Generally, banks and other financiers, when providing financial accommodation to their clients,
use bank-accepted bills and commercial bills. Promissory notes trade in the market on the
strength of the issuer’s name alone. The discount rate in promissory notes is higher than for
bank‑acceptance bills, but acceptance fees are avoided.

For example, a financing facility may have a term of two years or more. Individual bills, usually
denominated in amounts of $100 000 for terms of 30 to 180 days, would be issued at a discount
to their face value, so that the discount represents the interest paid to the financier to provide
its required yield. The instruments would then be rolled over each 30- to 180-day period and
discounted as before. The financier can sell the instrument into the market to re-liquefy its
position; that is, to fund its loan to its customer.
 116 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Pricing discount securities

In Australia, the method used to obtain the price of a discount security is to calculate the present
value of the payment due on maturity using simple interest, or discount, using a 365-day year.
Note that in some markets, notably the United States, a 360-day year convention is used.

The Reserve Bank of Australia (RBA) uses the following formula for the pricing of treasury notes:

100 000
P=
 n 
1 +  × r 
 365  
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where:
P is the price per $100 000 of face value;
n is the number of days to maturity; and
r is the simple interest per annum.

Example 2.5
Compute the price of a bank bill with a face value of $100 000, with 180 days to maturity and a required
yield of 6 per cent per annum.

The bill’s price is the present value of $100 000 at 6 per cent over 180 days:

100 000
P=
 180  
1 +   × 0.06 
 365  

P = $97 126.13

Suppose that an investor who purchased this bill decided to sell the bill 30 days later. Assume that
the required yield on the bank bill at that time was (a) 6.5 per cent per annum or (b) 5.5 per cent per
annum. What proceeds would the investor receive at these market yields?

The price of the bank bill 30 days later would be based on the market yield at that time and the time
remaining to maturity, which is 150 days. The new market prices of the bill are as given below.

At a market yield of 6.5 per cent the new price would be:

100 000
P=
 150  
1 +   × 0.065 
 365  

P = $97 398.27

At a market yield of 5.5 per cent the new price would be:

100 000
P=
 150  
1 +   × 0.055 
 365  

P = $97 789.69
 Study guide | 117

Other sources of short-term and intermediate-

term finance
Bank overdraft
An overdraft is a form of lending provided by a bank whereby a customer can overdraw a current
account up to an agreed limit. It provides funding on a fluctuating basis and repayments may be
made as desired.

Overdrafts are a simple and convenient form of bank borrowing. Interest is charged on the daily
balance owed, plus a nominal charge on the unused balance. They provide short-term finance

MODULE 2
on a flexible basis, and hence should be used for short-term purposes rather than to finance
medium- to long-term investments. Overdrafts may be secured by fixed or floating charge
over assets.

The principal disadvantage of bank overdrafts is that overdrafts are at call and must be repaid
on demand. Also, the interest rate may be varied at the lender’s discretion. Establishment and
service fees, and unused limit fees will also increase the cost of the facility beyond the apparent
or quoted rate.

Fully drawn advances

Fully drawn advances (FDAs) are used by banks to provide medium-term finance where there is
a primary requirement for debt finance. This is in contrast to overdraft facilities, which normally
are intended to cover fluctuating working capital requirements. FDAs are normally drawn in full
at the outset to provide for a specific capital need. They are not discounted instruments but are
repaid over a fixed term, usually between two and five years’ duration, by regular repayments of
principal and interest, structured to suit the cash flow of the borrower. Interest rates can be fixed
over the term of the loan, or may be floating, and are generally higher than overdrafts, where the
premium is a function of the longer term of the FDA.

Term loans
A term loan is an advance of money repayable in full by a fixed date. Such loans are commonly
used to provide consumer credit, mortgage finance and several forms of personal finance
by savings banks, building societies and credit unions. In the commercial sector, term loans
are commonly used to finance assets required for the expansion of an organisation, such as
commercial premises or export finance.

The term of such loans is usually one to five years, and they are normally repaid in instalments
over the life of the loan, although repayments may be tailored to suit the borrower’s needs.
The main advantage of term loans is the certainty associated with the conditions of the loan term,
such as repayments etc. Disadvantages include: the variability of the interest rate, which is at the
lender’s discretion; the charging of stamp duty on the face value of the loan; and the inflexibility
of conditions.
 118 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Trade finance
Trade finance is a form of finance commonly used by small and medium-sized enterprises. It is
a financing technique used to fund the manufacturing, sale and delivery of goods to foreign
buyers. Trade finance is therefore a common form of funding used by both importers, exporters
and others involved in international trade.

As trade finance involves an international trade transaction, it also means that risks that are
not usually present in domestic transactions are involved. These risks include a geographic
separation, operations under differing legal and banking systems, and the challenges of
recovering and returning goods. In addition there are also risks involved with the use of
international remittances using foreign currencies as well as new and unfamiliar political and
economic risks associated with cross-border trading.
MODULE 2

Trade finance usually commences with the setting up of a documentary letter of credit (DLOC).
A DLOC is in the form of a letter of promise by the bank to pay an exporter as long as the
exporter complies and delivers to the terms of DLOC.

Trade finance can take the form of trade and cash flow support, such as invoice financing, trade
advances, and services to provide businesses with protection from instances of non-payment or
performance.

Equipment financing
Several alternative forms of transactions may be used to finance plant and equipment. A brief
discussion of these sorts of financing transactions follows.

Leasing
Leases are a common form of financing businesses, from small operations to mining
conglomerates. The key benefit of a lease is that it permits access to plant, equipment,
property and software without a large initial outlay.

Technically, a lease is an agreement conveying the right, from a lessor to a lessee, to the
use of property for a stated period of time in return for a series of payments by the lessee to
the lessor. The terms of a lease agreement generally specify conditions relating to the period of
the lease, the amount and timing of lease payments, the cancellation rights of the lessee and
responsibility for the payment of insurance and repairs and maintenance of the leased property.

In addition, the amount of any guaranteed residual value included in the lease payments is
specified. The residual value is defined as the estimated fair value of the leased property at the
end of the lease term, based on price levels and market conditions existing at the inception of
the lease.

While there are currently two major types of leases covered by IAS 17 Leases, being operating
leases and financial leases, under proposed changes the distinction between these two types
of leases is to be eliminated and a ‘right of use’ concept will replace the current risk and benefit
concept. The International Accounting Standards Board (IASB) has issued a revised exposure
draft in 2013 which gives further clarity to the intended revisions to the standard.
 Study guide | 119

However, under current arrangements the distinction remains, as follows:

• An operating lease is a lease under which the lessor effectively retains substantially all of
the risks and benefits incident to ownership of the leased property. Operating leases were
initially designed for use where there was no intention on the part of the lessee to obtain
ownership at the end of the lease. These are rental agreements and apply to equipment such
as computers, telecommunications equipment and vehicles. They are cancellable given the
required notice to the lessor.
• A finance lease is defined in the standard as any lease which is not an operating lease and
which effectively transfers from the lessor to the lessee substantially all the risks and benefits
incident to ownership of the leased property without transferring legal ownership. Finance
leases were initially designed for the situation where the lessee wished to obtain substantially
all the economic benefits of an asset but wanted to avoid an immediate outlay of the cash

MODULE 2
price of the asset. Finance leases include an allowance for depreciation.

The essential distinction between these forms of lease is that operating leases are ‘off-balance-
sheet’ financing, whereas finance leases are ‘on-balance-sheet’ financing. It is worth noting that
the approach taken by the IASB Framework is that leases which are non-cancellable are to be
disclosed in the statement of financial position, irrespective of whether they are classified as an
operating or finance lease.

The proposed standard IAS 17 Leases will make no distinction between operating and financing
leases. Instead, all leases will be covered under the concept of a ‘right of use’ asset, which means
the ability to use a specified asset over the term of the lease. Thus, a different form of financial
statement reporting will be required.

This change to the accounting for leasing aims to provide the users of financial statements
with a clearer picture of the obligations of both the lessee and the lessor, and to facilitate a
better understanding of the debt financing as it relates to leases. The intention is to make the
accounting for leases properly reflect their substance in both the statement of financial position
and the cash flow statement.

Sale and leaseback occurs where an asset is sold to a financier then leased back to the seller,
thereby freeing cash for use elsewhere in the business. Thus, a right of use (ROU) asset and
an obligation to pay (OTP) liability would be identified at the start of the lease (netting to zero
at commencement and expiry). The ROU asset would be amortised over the lease’s life and
no lease expenses would be recognised. The OTP liability would decline against cash lease
payments over the life of the asset, so at the end, the OTP liability and ROU asset values would
both equal zero.

In the statement of profit or loss and other comprehensive income, charges are calculated on a
straight line basis over the period of the lease. Lessees will be required to account for all right-of-
use assets, including maintaining detailed sub-ledgers to keep track of each lease (or the liability
to make lease payments) both separately and as part of the ROU asset class. One implication is
that property, plant and equipment will need to be segregated between what has been bought
outright (however financed) and what has been leased (defined as ROU assets).

The resulting recognition of assets and liabilities by the lessee and lessor would be measured
on the basis that assumes the longest lease term that is likely to occur. It will include contingent
rentals together with penalties and residual guarantees and a requirement to update when
changes in facts or circumstances indicate there will be a change in the assets and liabilities
since the last reporting period.
 120 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Under the arrangements, it is likely that all leases will be calculated with respect to estimated
length of the lease and residual value, with these values being reassessed at the end of each
financial year (more accurately, at the reporting date).

Overall, rent expense is replaced by depreciation and the statement of financial position
grossed-up initially by the value of the lease (ROU and OTP). There would be no major change
to underlying business or underlying cash flows. The existing risk–reward concept is effectively
replaced by the right of use concept.

The major accounting change would be a large increase in interest-bearing debt, as previously
there was no ‘stock’ but rather only the ‘flow’ from rental payments.
MODULE 2

Accounting for leases is also discussed in the ‘Financial Reporting’ subject of the CPA Program.

Hire purchase
Hire purchase is a method of acquiring specific goods, normally plant or equipment, by
instalment payments. It differs from a lease in that ownership passes to the user when all the
payments have been made. The main advantage to the user is that it facilitates the purchase of
plant or equipment without immediate capital expenditure and (like leasing) its effect on cash
flow is predictable, thereby assisting in cash budgeting. Hire purchase contracts are usually from
three to five years in duration, and are therefore a form of intermediate-term financing.

Lease instalments attract GST, but the lessee can claim an input tax credit if they are registered
for GST. However, payments on hire purchase like those on a term loan or bond do not attract
GST as they are classified as ‘financial supplies’ which are input-taxed under the GST legislation.

➤➤Question 2.5
What sort of short-term finance would you expect to be used by the following and why?
(a) A large retail chain.
(b) A new car dealer.
(c) A suburban furniture store.
(d) The local subsidiary of a multinational motor-vehicle manufacturer.

Long-term debt financing

Long-term financing usually refers to the use of financing instruments which mature in two years
or more. Such finance takes the form of borrowing via the issue of debt securities or equity
financing (which is covered in the following section). In this section, we provide an overview of the
main types of long-term financing instruments, including their relative benefits and drawbacks.

For most large long-term borrowings, companies either require or strongly benefit from some
form of credit rating. This involves fees being paid to specialist credit rating organisations,
with around 90 per cent of all ratings provided by three US-based groups—Standard & Poor’s,
Moody’s Investors Service and Fitch Ratings.
 Study guide | 121

Table 2.3 is an example of the types of ratings provided by these agencies.

The higher the rating, the safer the organisation is deemed to be from the risk of financial distress.

It should be noted that as a result of the GFC and the European sovereign debt crises,
some questions are being asked as to the usefulness of ratings.

Table 2.3: Standard & Poor’s ratings

Business risk/Financial risk

Financial risk profile

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1 2 3 4 5 6 (highly
(minimal) (modest) (intermediate) (significant) (aggressive) leveraged)

Business risk profile

1 (excellent) aaa/aa+ aa a+/a a– bbb bbb–/bb+

2 (strong) aa/aa– a+/a a–/bbb+ bbb bb+ bbb–/bb+

3 (satisfactory) a/a– bbb+ bbb/bbb– bbb–/bb+ bb b+

4 (fair) bbb/bbb– bbb– bb+ bb bb– b

5 (weak) bb+ bb+ bb bb– b+ b/b–

6 (vulnerable) bb– bb– bb–/b+ b+ b b–

Financial risk core ratios

Cash flow > 60 45–60 30–45 20–30 12–20 < 12

(funds from
operations)/
debt (%))

Debt/ < 1.5 1.5–2.0 2.0–3.0 3.0–4.0 4.0–5.0 >5

EBITDA*

* EBITDA—Earnings before interest, taxes, depreciation and amortisation.

Source: Standard & Poor’s Financial Services LLC 2013, ‘Corporate Methodology’, Global Credit Portal,
19 November, accessed August 2014, https://www.globalcreditportal.com/ratingsdirect/
renderArticle.do?articleId=1218904&SctArtId=197085&from=CM&nsl_code=LIME&sourceObjectId=
8314109&sourceRevId=7&fee_ind=N&exp_date=20231120-03:57:33.

Another issue to consider is the time profile of debt. Two factors are important here. Firstly,
there must be a spread in the timing of fundraising and renegotiation to ensure a company is
not ambushed by a debt crisis such as the GFC. Secondly, time to maturity needs to be spread
in case of spikes in interest rates that could seriously impinge on achieving acceptable all-up
funding costs. Table 2.4 illustrates the type of spread over time and term of a reasonably typical
large organisation.
 122 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Table 2.4: Example of debt maturity profile

Acceptable range Preferred position

Maturity band (as authorised by the board) (risk management committee approved)

Short term

0–1 year 0–40% 30%

Long term

1–3 years 0–30% 10%

3–5 years 0–50% 20%

5–7 years 0–50% 40%

MODULE 2

There is an acceptable range within which the board of directors permits the funding program
to operate without further referral. However, the overall spread must be maintained and initial
raisings can be adjusted by the use of swaps to retain the overall mix mandated by the board
of directors.

Types of instruments
Bond markets
While overall the Australian bond market is small in terms of levels of outstanding debt
compared to other developed economies, the public debt market has grown significantly since
the onset of the GFC. This is illustrated in Figure 2.2.

Figure 2.2: Australian bonds outstanding

$b $b
Non-government**
400 400

300 300

200 200

Australian Government*
100 100

State governments
0 0
1994 1999 2004 2009 2014
* Excludes bonds purchased by the Australian Government
** Excludes ADIs’ self-securitisations, includes government-guaranteed bonds

Sources: ABS; RBA

Source: RBA 2014a, The Australian Economy and Financial Markets Chart Pack June 2014, p. 25,
accessed June 2014, www.rba.gov.au/chart-pack/pdf/chart-pack.pdf.
 Study guide | 123

The non-government debt market in Australia consists of four categories of issuers: financial
institutions, other corporate issuers, asset-backed issuers and non-resident kangaroo issuers
(which will be discussed under ‘Foreign bonds’). As further illustrated in Figure 2.3, while all four
segments of the market have grown over time, up until recently, financial institutions have had
the largest share of issues. While the growth of asset-backed issuance was severely affected
by the GFC, demand for the relatively high-coupon Australian-dollar assets has resulted in a
significant increase in the issuance of Australian-dollar debt by non-residents.

Figure 2.3: Non-government bonds outstanding

$b $b

MODULE 2
Financials

150 150

Asset-backed securities*
100 100

50 50
Non-financial
corporates
Non-residents
0
1994 1999 2004 2009 2014
* Excludes ADIs’ self-securitisations
Sources: ABS; RBA

Source: RBA 2014a, The Australian Economy and Financial Markets Chart Pack June 2014, p. 25,
accessed June 2014, www.rba.gov.au/chart-pack/pdf/chart-pack.pdf.

Bonds are a form of debt (as distinct from equity) finance. The normal or ‘vanilla’ bond involves
payment of a fixed amount (coupon) against the face value over a period of years, or variable
income (Floating Rate Notes) where payment is by reference to a benchmark rate, commonly the
bank bill swap rate (BBSW).

Bonds listed on a stock exchange such as the Australian Securities Exchange (ASX) can be
on‑sold or traded at a price that may vary from the face value of the bond. The price varies
with current interest rates (comparative investments) as well as the perceived creditworthiness
of the issuer.

For example, a bond may have been issued at a 6.00 per cent coupon rate on a face value
of $100. If the company is downgraded, the bond may resell for $85. In this case the yield
(also called running yield) is $6/$85 or 7.06 per cent. Very risky bonds under investment grade
(BBB or lower in Table 2.3 above) are known as ‘junk’ bonds—which require high returns to justify
their purchase. An example would be 10-year Greek Government bonds, which ranged between
15 and 37 per cent per annum over the 2011/12 financial year.

There are many other types of bonds, tailored to the needs of issuers and/or perceived market
opportunities. These include zero coupon bonds, where the bonds pay no interest but are issued
at a significant discount to their face value and have interest effectively deferred until maturity.

In Australia there are bond markets for government and corporate issuers and these will be
covered in turn.
 124 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Government and semi-government bonds

Australia has a relatively small government bond market, largely due to the low level—by world
standards—of government debt. In addition to the Australian Government, semi-government
entities such as state and local governments and their instrumentalities are also debt-security
issuers, with most semi-government paper issued with fixed-rate interest coupons for maturities
of five, seven or 10 years. Most state government funding agencies, such as the New South Wales
Treasury Corporation or the Queensland Treasury Corporation, also raise funds directly from
the public.

However, as a result of the changes to the requirements for banks and other ADIs to hold greater
levels of quality paper under Basel II and also internal upgrades of risk capital requirements, it is
likely that there will be considerable pressure on governments to increase the supply of securities
MODULE 2

to deepen the secondary markets in these instruments.

Corporate bonds
In the past decade the Australian corporate bond market has lagged behind both the Australian
corporate loan market and the Australian corporate offshore bond market. This was the result
of corporates having been well serviced by bank and syndicated loans. It also stemmed from
an increased ability to secure funds in the offshore bond markets, which also provide a natural
hedge against foreign currency exposures. In addition, Australia’s more than AUD 1.5 trillion
superannuation fund industry was heavily focused on equity investments and much less so
on fixed income allocations.

According to the RBA (2014b), Australian corporate bonds issuances represent less than
1 per cent of Australian GDP, with only a third of these issuances taking place in the domestic
market. The market value of domestic bonds outstanding has remained relatively stable over the
last 10 years at around $50 billion, while offshore issuances have increased three-fold during that
time to around $170 billion. These figures compare to the total corporate debt outstanding of
approximately $920 billion, highlighting the strong preference for loans and other debt securities.

Other forms of capital raisings

There are several other forms of debt capital raisings available to organisations. These include
asset-backed securities, debentures and unsecured notes. Each will be covered in turn.

Asset-backed securities
‘During the period of expansion [prior to the GFC], an increasingly significant source of funding
for financial institutions was the asset-backed securities market. The best example of this was
residential mortgage-backed securities (RMBS) which grew rapidly as a share of the mortgage
market’ (Debelle 2011). After the commencement of the GFC, the structured credit products’
share of the market declined sharply—see Figure 2.4 (AOFM refers to the Australian Office of
Financial Management, which oversees Australia’s federal debt management for the Australian
Treasury).
 Study guide | 125

Figure 2.4: Australian RMBS outstanding

$b $b

150 150

100 Offshore 100

AOFM
50 50

MODULE 2
Onshore

0
1996 2000 2004 2008 2012
Sources: AOFM: Bloomberg; RBA; Standard & Poor’s

Source: G. Debelle 2012, ‘Enhancing information on securitisation’, Address to Australian

Securitisation Forum, Sydney, 22 October, accessed June 2014,
http://www.rba.gov.au/speeches/2012/sp-ag-221012.html.

Debentures
A debenture is a security issued in exchange for a secured loan obtained from an institution or
from individual investors. Debentures normally carry a fixed interest rate, have a fixed maturity
date at which the face value is repaid, and are secured by a fixed charge over a specific asset or
by a floating charge over the unpledged assets of the company. Most company debentures are
listed on the stock exchange and may be traded in a similar fashion to ordinary or preference
shares. The amount paid on maturity is usually the face value, but debentures may be issued at a
premium or discount.

Debentures may be issued via a general offer to the public, via a private placement with a
financial institution or via an offer to existing shareholders or debenture holders (known as a
family issue). The term of a debenture may vary from one year up to 15 or 20 years.

In Australia, all debentures must be secured and the security for debenture holders is specified
in a debenture trust deed, which is a legal document that specifies the restrictions, undertakings
and covenants of the contract. A trustee is appointed who ensures that the company complies
with the conditions of the contract and who takes legal action to protect the interests of
debenture holders should any of the conditions of the trust deed be violated. The conditions of
the trust deed typically include restrictions on the following:
• Future borrowing. To ensure that the position of debenture holders is not prejudiced by the
raising of additional debt in the future, restrictions are placed on the amount of future debt
that can be raised. This restriction includes not only future secured debt but unsecured debt
as well.
• Liability restriction. In addition to placing restrictions on future borrowing, the trust deed
may also require that companies maintain a specified asset balance. This could be breached
if, for example, the company’s total tangible assets fall, even without additional borrowing
commitments being entered into.
• Earnings requirements. To ensure that debenture interest can be met out of current
earnings, trust deeds may also specify an earnings coverage requirement which may further
restrict the ability of the company to engage in further borrowing.

In recent years, the popularity of debentures as a source of finance has decreased considerably,
with issuers preferring unsecured notes as being more flexible with less onerous issuance
requirements.
 126 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Unsecured notes
These are a form of re-emergence of corporate debentures, now going under the name of
subordinated notes.

Like a debenture, an unsecured note is a security issued in exchange for a loan, which commits
the borrower to a series of periodic interest payments and repayment of the principal on the
maturity date. However, unlike debentures, no security is offered on notes, so that note holders
rank behind debenture holders, and, as such, have equal ranking with normal (unsecured)
trade creditors in terms of seniority of claim. As a result of this difference in risk, notes carry a
higher interest charge than debentures with otherwise similar characteristics. Again, the use of
unsecured notes as a financing tool has declined considerably in recent years.
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Debt restructuring
There are four major forms of debt restructuring. Each is discussed in turn.

Debt repurchase programs

These programs involve a formal repurchase offer to debenture holders by which the issuer offers
to redeem all outstanding debentures, usually at a price below par but above the current market
price. Consideration may be cash or other securities with comparable risk and maturity but with
higher yield.

Debt repurchase on the open market

Rather than make a formal repurchase offer, a company may repurchase its own debt through
open market transactions. This would be the only alternative to a repurchase offer in cases where
bearer securities are involved, since the issuer does not have a register of current debt holders.

Debt switches
This process involves an agreement with holders of debt whereby they agree to the early
redemption of existing debentures and to receive alternative securities. The alternative securities
can take a number of forms, depending on the objective which the company is trying to achieve.
For example, the New South Wales Treasury Corporation has employed a policy of substituting
Premier State Bonds for the outstanding securities of state government authorities, such as the
State Rail Authority, on broadly matched terms.

Debt defeasance
Some debenture holders may be unwilling to recognise the loss which would arise if they
accepted a formal repurchase offer, thereby blocking a debt-restructuring plan. To overcome
this, the technique of defeasance was developed as a means by which a debtor may be released
from the primary obligations for a debt. A legal defeasance means a defeasance in which the
release of the debtor from the primary obligation is either acknowledged formally by the creditor
or by a duly appointed trustee of the creditor, or established by legal judgment.

An in-substance defeasance is a defeasance other than a legal defeasance in which the debtor
effectively achieves release from the primary obligation for a debt either by placing in trust assets
which are adequate to meet the servicing requirements (both interest and principal) of the debt
or by having a suitable entity assume responsibility for those servicing requirements.

As the difference between the book value of the debt and the assets transferred to the trust fund
is treated as profit to the borrowing organisation, the resulting tax implications mean that this
technique has virtually ceased to exist.
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Negative pledge borrowing

Rather than borrow on a secured basis, with the attendant restrictions imposed by a trust
deed, many organisations have now adopted the technique of negative pledge borrowing.
This involves the raising of unsecured debt, principally from the banking sector, but with an
undertaking (pledge) by the borrower not to provide a higher ranking security to any lender,
or the limiting of any new security to a dollar or percentage figure. The pledge can recognise
existing secured borrowing at the time of drawing the pledge; normally, such borrowings could
not be increased without trustee’s and/or lender’s approval. The limitation of this borrowing
technique is associated with enforcing the pledge as the borrowing is unsecured.

An advantage of negative pledge borrowing is that the assets of overseas subsidiaries can be
included in the definition of total tangible assets, whereas overseas assets are usually excluded

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from the asset definition employed in trust deeds. However, care must be taken to ensure that
such assets are available to satisfy a domestic loan, should enforced realisation of overseas
assets be required. The corporate collapses of the late 1980s caused the use of this technique to
decline significantly. Credit standards tightened, with the emphasis on security and sustainable
cash flows.

Seniority of debt instruments

Loans to an organisation will carry differing rights as to the priority of interest payments and
capital repayments. Senior securities are those which rank first in the priority order with respect to
those payments. Generally, debentures, being secured by a floating charge over the assets of the
organisation, rank ahead of all other debt. At the other end of the scale, subordinated debt ranks
below all other liabilities of the organisation. This means that subordinated debt ranks ahead of
only equity capital and, therefore, has some of the qualities of equity. The longer the term of such
loans, the more they resemble equity in the eyes of other lenders to the same company. The use
of subordinated debt was due to lower after-tax cost of such debt relative to equity and to the
capital adequacy provisions of the RBA which permit subordinated perpetual debt to be included
in the definition of a bank’s capital.

Offshore long-term debt and equity fundraising

Australian corporate borrowers can raise debt funds internationally, especially in the Euro‑markets,
the US and Japan. These are covered below.

Foreign bonds
Foreign bonds are those bonds that are issued by a borrower to investors in a country other
than the borrower’s home country, with the bonds being denominated in the investors’ currency.
An example of a foreign bond is BHP Billiton issuing Japanese yen denominated bonds in Tokyo.
Since the bonds are sold in the domestic market of the investors, they need to comply with the
legal and institutional requirements of that market. Foreign bond markets pre-date Eurobond
markets and are increasing in terms of relative importance compared to the euro-markets which,
until recently, dominated in terms of number and market value of bonds on issue.

Australia’s relatively high interest rates compared with the near-zero rates in Japan, Europe and
the US have made Australia attractive to overseas fixed-income investors and, in turn, given
Australian banks more access to offshore investors, particularly in Japan. Australian banks have
lowered their reliance on overseas funding in recent years with domestic deposits (as a share of
total funding) increasing significantly.
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Some foreign issuer bonds are called by their nicknames, such as the ‘samurai bond’. These bond
issues are generally governed by the law of the market of issuance (e.g. a samurai bond, issued by
an investor based in Europe, will be governed by Japanese law). Most of the bonds are restricted
for purchase by investors in the market of issuance.

Some examples of foreign bonds include the following:

• Bulldog bond—a sterling-denominated raising in the UK by a non-British issuer.
• Kangaroo bond—‘an Australian dollar-denominated bond issued by a non-Australian entity
in the Australian market’—the fastest-growing segment of the Australian capital market over
much of the past decade, as illustrated in Figure 2.5.
• Kauri bond—a New Zealand version of the Kangaroo bond.
• Maple bond—‘a Canadian dollar-denominated bond issued by a non-Canadian borrower in
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the Canadian [capital] market’.

• Matrioshka bond—‘a Russian rouble-denominated bond issued in the Russian Federation
by a non-Russian’.
• Panda bond—a Chinese renminbi-denominated raising in China by non-PRC source.
• Samurai bond—‘a Japanese yen-denominated bond issued by a non-Japanese borrower
in Japan’.
• Yankee bond—‘a US dollar-denominated bond issued by a non-US entity in the US market’
(Wikipedia 2012).

Figure 2.5: Non-resident AUD bonds outstanding

%
(share of total)
100

75
Kangaroos

50
Eurobonds

25

0
2003 2005 2007 2009 2011
Year

Source: G. Debelle 2011, ‘The Australian bond market in 2011 and beyond’,
KangaNews Australian DCM Summit, Sydney, 15 March, accessed June 2012,
http://www.rba.gov.au/speeches/2011/sp-ag-150311.html.

Euro-markets
The euro-markets can broadly be classified as eurocurrency market and eurobond market.

The eurocurrency market consists of banks that accept deposits and make loans in euro—that
is, a currency deposited in a bank that is located in a country which is not the native country of
the currency. Thus, the market for US dollars outside the US is called the eurodollar market and
represents the market for US dollar deposits and lending outside the United States. Alternatively,
the market for Australian dollars outside Australia would be termed the euro-Australian dollar
market, and for UK sterling, euro-sterling.
 Study guide | 129

The eurocurrency market is the part of international financial markets where short-term funds
are borrowed and loaned among non-residents and/or in foreign currencies. The borrowing and
lending is conducted via Eurobanks. For example, a Eurobank in London that has a deposit of
USD 1 million is said to have a euro-dollar 1 million deposit. If the same bank loans AUD 5 million
to a Japanese company it has created an AUD 5 million euro-AUD loan. Other than the US dollar,
the euro, Japanese yen, pound sterling and Swiss franc are the most common eurocurrencies in
which funds are borrowed and loaned.

In a similar way to the eurocurrency market, the market for long-term instruments is referred to as
the eurobond market.

This is to be distinguished from the euro, which is the actual currency of the majority of countries

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that operate within the European Union and allied neighbours. Deposits in euros outside the
eurozone would be called euro-euro deposits.

Eurobonds
Eurobonds are fixed-interest bonds usually underwritten by a syndicate of international
investment banks sold in countries outside the country in whose currency the bond is
denominated. An example of a Eurobond issue would be US dollar-denominated bonds
issued by the ANZ Bank in London, or Japanese yen-denominated bonds issued by a
US‑based company in Zurich and London. Being unsecured, they are generally issued by
large, highly creditworthy borrowers in large amounts, typically USD 500 million or more.

Bond maturities are typically five years, although longer-term issues are sometimes made.
Australian companies such as BHP Billiton as well as public sector borrowers, also raise funds in
this market. The major purchasers of Eurobonds are institutions such as insurance companies,
superannuation and pension funds, central banks and large multinational corporations.

There are three main factors that have driven the growth of the Eurobond market:
1. the absence of regulatory interference;
2. relatively limited disclosure requirements; and
3. in some areas, tax anonymity.

The Eurobond market falls outside the regulatory scope of any one national government as
Eurobonds are placed and traded offshore.

From the perspective of investors, Eurobonds are ‘bearer’ bonds, which means that there is no
registration of ownership, and interest and principal are paid to nominated accounts—or in some
cases, on presentation of coupons, over the counter in the form of bank cheques. They therefore
offer tax anonymity as well as a possible mechanism for tax avoidance by the black economy.

Eurobonds should be distinguished from issues of European bonds, which are frequently but
incorrectly labelled Eurobonds. These are bonds that would be issued and backed jointly by the
17 eurozone countries.

Types of Eurobonds
Fixed-rate bonds comprise the majority of bond issues and are attractive to issuers as they
provide a fixed borrowing cost. Floating-rate notes (or FRNs), like their domestic counterparts,
have their interest rates periodically adjusted according to current market rates. The most
commonly used reference rate is the London interbank offer rate, or LIBOR. Australian banks use
this method of fund raising and on-lend funds raised to their corporate borrowers at a margin
above their funding rate.
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FRNs have an advantage over fixed-rate bonds in market environments characterised with
interest-rate volatility, as investors are unwilling to hold long-term fixed-rate bonds. In a climate
of reduced volatility (such as 2012–13) FRNs are less popular—and in addition to these more
common types of Eurobonds, there are many other variations available to borrowers and
investors, including convertible bonds, zero-coupon bonds and multi-currency bonds.

US markets
In the US market there are three groups of bond maturities:
• short-term (bills): maturities between one to five years (instruments with maturities less than
one year are called money market instruments and include US commercial paper);
• medium-term (notes): maturities between six to 12 years; and
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• long-term (bonds): maturities greater than 12 years.

This section only discusses US commercial paper.

US commercial paper (CP)

Australian corporate and public sector borrowers may raise funds through the US money markets
by the sale of negotiable bearer securities known as commercial paper (CP). Commercial paper
is a short-term financing instrument, ranging in maturity from 30 days and above. Issues may be
underwritten or distributed through a syndicate of large investment banks and will inevitably
require a credit rating by one of the international rating agencies such as Moody’s Investor
Service or Standard & Poor’s.

Australian corporate borrowers in this market include the major Australian banks. Public sector
borrowers include the various state government financing authorities. In recent years, Australian
companies have also accessed US capital markets via private placements under Rule 144A where
the US Securities and Exchange Commission (SEC) relaxed its restrictions on who could purchase
and trade unregistered securities. Under Rule 144A qualified institutional buyers (usually large
financial institutions) are permitted to trade unregistered securities among themselves.
The improved liquidity and lower interest costs associated with issuing these unregistered
securities have resulted in the growing popularity among Australian companies.

US private placements and ADRs

The US private placement market is the non-public offering of securities which is sold to a,
usually small, number of selected large investors. These types of securities, while subject to the
US Securities Act of 1933, do not have to be registered with the US regulator—the Securities and
Exchange Commission (SEC)—if the placement conforms to the issuing guidelines for exemption
from the Act and allied SEC regulations. It is thus a less costly way to issue and administer
equity raisings in the US equity markets. Foreign companies wishing to raise equity funding in
the large and deep US capital markets can do so without the sometimes onerous due diligence
and ongoing reporting costs of a more public equity offering.

Another way of accessing equity finance is through the raising of American depositary receipts
(ADRs) which are the US dollar denominated, US-listed equivalents of the securities of non-US
companies. These are tradeable, like regular listed stocks of US domestically listed companies,
and pay their dividends in US dollars. ADRs allow US investors to buy the securities of foreign
companies without the accompanying risks of cross-currency and jurisdictional purchases and
sales of foreign stocks.
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Administratively, an ADR is issued as a security by a sponsoring US custodian bank where the

underlying shares that back the ADR are deposited with a counterparty depository bank residing
in the local market of the foreign-listed company. The ADR thus represents the tradeable
fractional beneficial interest in those shares held with the depositary bank. The benefit to the
local (US) investor is that it gives convenient transactional and tradeable access to foreign stocks,
while the benefit to the issuer is that it broadens the market for its equity (and range of potential
investors) without necessarily listing on the US market (with its resulting start-up listing, and
subsequent reporting obligations and costs).

Asian markets—Japan
The samurai bond market—being yen-denominated bonds issued in Japan by non-Japanese

MODULE 2
entities—has traditionally been heavily regulated, although this has changed in recent times.
In addition to samurai bond issuances, there have been issues in the euro-yen market, which is
slightly different in that no disclosure is required in Japan. The euro-yen is faster, cheaper and
involves less documentation, but the samurai is more appropriate for most non-banks.

➤➤Question 2.6
Distinguish between a domestic bond, a foreign bond and a Eurobond in relation to:
(a) the issuer’s place of residence;
(b) the currency of the issue; and
(c) the investor’s place of residence.
What do you think are some of the factors that might influence a company’s decision as to which
bond to issue?

Equity financing
Equity capital refers to capital which has been provided by individuals and entities in exchange
for part or full ownership of an organisation.

Any discussion of equity capital and equity financing in Australia involves discussion of Australia’s
largest equity market, the ASX.

The ASX is subject to the Corporations Act 2001 (Cwlth), and there are specific sections that deal
with the holders of an Australian market licence. Section 792A sets out the general obligations
and specifies that the holder of an Australian market licence (including the ASX) is required to
ensure that the market is fair, orderly and transparent.

The marketplace provided by the ASX consists of both the primary market and secondary market.

The primary market relates to ASX-listed companies raising money for the first time in the form
of initial public offerings (IPOs), rights issues, placements, dividend reinvestment schemes and
employee share ownership schemes.

The secondary market is one that most would be familiar with, that is, the buying and selling
of shares in companies which are listed on the ASX. The purchase and sale of shares on the
secondary market has no direct effect on the underlying viability or profitability of the company
concerned. It is the primary market which provides funds (equity capital) to the company
concerned. In recent times the value of existing shares (total domestic capitalisation) totalled
over AUD 1 trillion in each of the five years to June 2013.
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Debt versus equity and the GFC

In the context of this module on the sourcing and management of debt, it is worth revisiting
the topic of the GFC first raised in Module 1 with an emphasis on the capital and financial
instruments issues involved.

The collapse of Lehman Brothers in 2008 was the trigger for the GFC. Part of the reason for
Lehman Brothers’ collapse was the fact that it had been a central player in securitisation.

Securitisation involves the bundling of a range of assets that have cash flows associated with
them, then splitting these assets into pieces of paper called securities, which in turn are bought
by investors around the world, including major commercial and investment banks. In relation to
the GFC, what has now become clear is that the assets on which the securitisation was based
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included residential mortgages (subprime mortgages in the United States) outstanding credit
card liabilities and car-leasing liabilities, which were bundled then securitised. This became a
major problem when one link in the chain broke (i.e. individuals who held subprime mortgages,
for example, were unable to meet their commitments). Thus a break of one link in the chain
rendered the securitised pieces of paper largely unsaleable. A chain reaction then flowed
through to investment houses and banks which had purchased the securitised paper, in many
cases via Lehman Brothers.

This situation developed into a crisis of liquidity—banks were disinclined to lend to other banks
that were believed to have a large exposure to these securitised pieces of paper. Accordingly,
the financial system experienced a crisis situation in September and October 2008.

However, subsequent action by governments and central banks around the world to inject
capital into banks, to nationalise banks, to provide guarantees to bank deposits and to wholesale
borrowing by banks, coupled with reductions in official interest rates and trillions of dollars of
fiscal stimulus across many countries, stabilised the situation.

In early 2010, it was revealed that the Greek authorities had been publishing inaccurate statistics,
such as announcing a budget deficit of 8 per cent of gross domestic product that was in fact
around 14 per cent, and that overall Greek debt was well in excess of 100 per cent of gross
domestic product. This triggered what is now known as the European sovereign debt crisis.

The eurozone has agreed on an austerity program for all high debt countries, with the emphasis
on reducing expenditure and eliminating waste. This austerity program has led to a contraction
in the countries that have enacted the programs, with the result that many European countries
experienced bouts of negative growth between 2010 and 2013, and part of 2014.

In 2012, the European leaders agreed to a framework for the future operation of the euro,
with deficit-to-GDP limits being placed on member countries with targets to be achieved over a
period of five to seven years. This new framework was intended to provide a fiscal rigour which
had been absent from the inception of the euro. This decision was then followed up with a
decision by the five major central banks of the world (the United States, Britain, the European
Central Bank, China and Switzerland) to provide subsidised US dollar loans to various indebted
countries if that became necessary, and a decision by the European Central Bank to provide
liquidity to member countries’ banks to in turn facilitate lending to repay debt or stimulate activity.

The implications for global capital raising—both debt and equity—were, and continue to
be, profound and long-lasting. The credit crunch (also known as the ‘credit squeeze’) which
immediately preceded and caused the GFC resulted in a general reduction in the availability
of loans and credit. There was a re-rating of credit risk, with the relationship between credit
availability and interest rate changes becoming more independent. Thus the debt markets in
2008 began practising a form of credit rationing, often accompanied by a flight to quality by both
investors and lenders.
 Study guide | 133

In practical terms, small to medium-sized companies tended to face tightened credit terms
with the risk premium and loan margins over official rates rising significantly into 2007–08.
The resultant cash flow pressures restricted businesses’ ability to grow, pay day-to-day expenses
or to meet their debt obligations as and when they fell due. The response to these risks was to
begin a process of deleveraging or paying down portions of debt obligations.

This is in contrast to the years leading up to the GFC, where companies used debt financing
and borrowed heavily due to the perceived taxation benefits of debt and high gearing. But an
overload of debt in the wake of the subprime crisis and fragile share markets, commencing
with the collapse of Bear Stearns in the United States in March 2008 and a number of other
high‑profile corporate failures, meant that banks became less able to lend to corporations which
were seeking to refinance their debt obligations.

MODULE 2
While there were no major financial collapses in Australia, a large number of highly geared
companies did collapse, including ABC Learning, Alco Finance and Babcock & Brown.

As a result, companies that were excluded from the debt market looked to raise equity capital
to strengthen their balance sheets. These corporations issued equity capital (the primary market)
in the form of placements, rights issues and share purchase plans. These issues were made at a
substantial discount to the already low pre-existing share prices for those companies and were
very attractive. For example, in the year to September 2009, over USD 90 billion of new equity
was raised, which compared with average annual capital raised over the previous 10 years of
USD 40 billion.

The Australian share market constitutes about 2.4 per cent of the world’s market capitalisation,
sitting in eighth position and well behind the top major countries of the USA (35%), China (7%),
Japan (7%) and the UK (3.7%). Note that, increasingly, with the integration of national exchanges
along more regional and global levels, organisations are no longer restricted to listing and
issuing equity capital in their country of origin or operations. For example, BHP, which was
originally listed in Australia, has since become dual listed on the London stock exchange after
merging with the UK-based mining company Billiton (in 2001) to become BHP Billiton, but also
has ADRs on issue on the US exchanges. Indeed, the very stock exchanges themselves are
subject to regional and global mergers, as witnessed by the Singapore Stock Exchange (SGX)
attempting (in 2011) to merge with the ASX.

Forms of equity financing

Ordinary shares
‘Ordinary’ shares, which carry one vote for each share, can be distinguished from other kinds of
shares such as preference shares. Preference shares have different voting rights attached to them
and generally provide these shareholders with the right to vote on issues which affect preference
shareholders. Also, preference shareholders receive priority over ordinary shareholders in the
winding-up or liquidation of a company.

Equity capital also means that the persons who provided the capital, being the owners of the
company, see their fortunes fluctuate in direct relationship to the profitability or otherwise
of the company itself. If the company is profitable, the owners have a share in those profits
through an increase in the value of the original investment or in the form of dividends which are
paid out of the company’s profits on a periodic basis. With companies which are listed on the
stock exchange, dividends are generally paid twice a year, although there is no obligation on a
company to pay dividends on a regular basis.
 134 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Equity ‘securities’ are documentary evidence that a person owns a portion of a company in
proportion to the amount of funds which they have subscribed, and are tradeable.

Equity capital should be distinguished from debt capital or loans which the owners of an
enterprise may borrow from a bank or a lending institution. Loans, of course, have to be repaid—
in most cases with interest. In contrast, equity capital, which an owner subscribes to the company
in return for shares, means that equity capital is embedded in the enterprise with no obligation
on the enterprise itself to repay to the owner the funds subscribed.

The equity capital of companies takes the form of shares in the ownership of the enterprise.
Equity capital can take various forms from pure equity or shares carrying one vote, through
hybrids which contain elements of debt and equity, to newer forms of capital such as converting
MODULE 2

and convertible preference shares.

Bonus shares
Bonus shares are ‘ordinary shares’ which are issued by a company for no consideration. The effect
is simply to increase the number of ‘ordinary shares’ on issue with the result that the price per
share decreases in an inverse relationship to the number of bonus shares issued.

Venture capital
Venture capital is a particular type of equity capital. It is capital which is sought and provided to
start up higher-risk ventures. Generally, the organisations that seek venture capital tend to be
smaller entities seeking to further the owners’ ideas but which have difficulty raising funds.

Venture capital can help new organisations to grow. It is a valuable source of funds for
entrepreneurs who otherwise would be forced to rely on loans from friends, relatives or banks.
Furthermore, banks and other lenders in many instances require substantial collateral that the
entrepreneurs may not possess. In most cases venture capital takes the form of equity capital
which the venture capitalists invest in the venture itself.

The number of initial public offerings for venture capital vehicles declined sharply following
the onset of the GFC. However, as the economy improves, entrepreneurial enterprises such
as mining exploration companies and smaller companies will be encouraged to seek venture
capital through the issue of new shares on the ASX.

Listed and non-listed companies

In Australia, there are over 2.1 million corporations, with about 3000 of these being public
companies (i.e. which have the suffix Limited or Ltd). The remainder are private or proprietary
limited companies (i.e. which have the suffix Pty Ltd).

The directorships and shareholder requirements for proprietary limited and limited companies
are as follows:
• Companies, whether they are public or private, are required to have at least one member
or shareholder. Proprietary companies must have less than 50 non-employee shareholders.
A public company must have at least three directors, and at least two directors must
ordinarily reside in Australia.
• Proprietary companies must have at least one director and that director must reside
in Australia.
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The companies which are listed on the ASX are public companies, or no-liability companies.
While proprietary limited companies are not precluded, it would be difficult for them to gain
listing on the ASX for reasons outlined in Part E of this module. In 2014, there were over 2100
companies listed on the ASX (ASX 2014a).

Mechanisms for raising equity capital

Companies list on the ASX for a number of reasons. They may require start-up capital for new
ventures or to fund exploration programs or to provide vendors with value for the capital which
they may have put into the company. Alternatively, a company may list on the market to reduce
the debt within the company itself.

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There are 10 general methods for the companies to raise equity funds, including hybrid forms of
equity raising. These are covered in turn.

1. New float or Initial public offering (primary issue)

A new float or initial public offering (IPO) is the method by which companies not previously listed
on the ASX can raise funds through issuing equity.

There are two main parts to the IPO:

1. Preparing for the float. There may be a need to restructure the company prior to the
float (much like preparing a home for an auction). Underwriters are normally appointed
to manage the float. The underwriters are responsible for preparing the documentation,
legal requirements, determining the general parameters to price the issue and arrange
sub‑underwriters—groups willing to guarantee the issue by accepting an undertaking to
take some of the shares for a fee.

2. Pricing the issue. This involves utilising the valuation techniques, including estimating the
net present value (NPV) of forecast earnings, price/earnings multiples on future profits and
cash flow multiples on forecast cash earnings.

There is normally a ‘book-building’ exercise by the underwriter to establish likely bids from
institutional investors at a range of potential prices. This is done as a heavily oversubscribed issue
normally means that the issue is underpriced and pre-float owners will not be fully compensated.

2. Issue of shares to existing shareholders: Rights or pro rata issues

A rights issue involves providing each existing shareholder with a right to buy additional shares
in a company at a specified price. This form of capital raising is called a rights issue because
each shareholder has the right to participate in the issue in proportion to the number of shares
held in the company. Rights issues are often called pro rata rights issues, that is, in proportion to
shares held.

Rights issues can either be renounceable or non-renounceable. Renounceable rights issues

entitle the shareholder to participate in the purchase of additional shares through the payment
of a premium, or to sell the right to acquire the shares on the share market. This makes the
issue much easier to price. The issue can also be on a partly paid basis, so a portion of the costs
is deferred (say 50% on issue and 50% three months later). Non-renounceable rights issues
(or entitlement issues) cannot be traded on the share market; that is, the shareholder cannot
renounce their right to participate through selling this right on the share market. If a shareholder
does not take up the right, an underwriter to the rights issue will be able to take up the right.
 136 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

The theoretical value of the right depends on the share price prior to the issue, that is cum-
entitlement, the ratio of the new issue and the issue price of the new shares. The theoretical
value is determined by the formula:

R = N (P – S ) / NN + 1)

where:
R = theoretical rights value
N = number of existing shares which must be held to receive the new issue
S = the subscription price of the new share
P = the market price of the existing shares post-announcement.
MODULE 2

For example, a one-for-five issue at $2 per share with market price of the existing share being $3:

R = 5 ($3 – $2) / (5 + 1) = 83.3 cents.

Many large issues are priced at between 50 and 80 per cent of the pre-announcement market price.

Rights issues are used where a company requires funding to finance an acquisition or to raise
funds for investment, or to reduce the level of debt within an organisation. Rights issues are
generally undertaken on an orderly basis over a period of time. This characteristic differentiates
rights issues from placements.

A prospectus or product disclosure document must accompany rights offers to clients.

3. Placements
Placements is a generic word used to cover the raising of additional funds, other than by a
pro rata rights issue, by companies which are already listed on the ASX. The rules governing this
form of capital raising are referred to in Chapter 7.1 of the ASX Listing Rules.

In summary, the rules provide that a company may make an issue of ordinary securities to
investors which total not more than 15 per cent of the number of equity securities on issue
12 months before the date of the issue. This form of capital raising can take place without the
approval of ordinary shareholders.

It should be noted that placements may not require the issue of prospectuses. Prospectuses are
comprehensive documents setting out the rights and obligations of the issuer in respect of the
issuing of shares, and are required to contain all the relevant information which an investor would
need to make a decision about whether or not to subscribe to the issue of particular securities.

In the case of placements, in order to avoid the prospectus requirements, each person who
subscribes to the placement must subscribe for an amount of funds of at least $500 000 or meet
the requirement to be a sophisticated investor as referred to in s. 708(8) of the Corporations Act
2001 (Cwlth) or is an ‘experienced’ investor as referred to in s. 708(10).

The Corporations Act enables shareholders to subscribe for an additional amount of $15 000
worth of shares in a company, through ‘share purchase plans’ at the time of the half-yearly and
annual reports of the company concerned.
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Placements can be distinguished from rights issues because placements are mechanisms by
which companies can raise funds quickly. In some cases, placements can be completed on
an overnight basis. In these situations the company concerned will make arrangements with
brokers or corporate advisors, who are in positions to marshal the funds required expeditiously.
Also, companies may use placements because the cost involved is lower than for rights
issues. The preparation and distribution of the prospectus, which is a requirement for rights
issues, entails an absolute dollar cost. The main disadvantage of placements is that existing
shareholders are left out of the issue.

However, the speed with which placements take place, the limited number of participating
shareholders, and the potential for dilution of the interests of non-participating shareholders,
have led the ASX to make rules that limit placements to a value of no more than 15 per cent of

MODULE 2
the capital of the company in the 12 months prior to the date of the placement issue.

4. Dividend reinvestment plans

Dividend reinvestment plans (DRPs) have been and still are popular for three reasons:
(a) They are a simple and efficient way for listed companies to raise capital without the
associated logistic, administrative and regulatory difficulties associated with placements
and rights issues.
(b) It is difficult for companies to raise funds when the share market is in a ‘bearish’ period.
In such a market it is often very expensive to raise funds, as companies have to issue more
shares to raise a given amount of capital.
(c) DRPs provide a means for distributing the franking credits associated with dividend payments
to shareholders without the need to actually pay those dividends as would be required with
cash dividends.

5. Employee share-ownership schemes

Another method of fund raising by companies has been through the issue of employee share-
ownership schemes. These have been a very important means of rewarding employees other
than through the payment of wages and salaries. In addition to providing employees with a
stake in the ownership of the company, it has been argued by proponents of employee share-
ownership schemes that these schemes increase the motivation of employees to contribute to
the overall productivity, efficiency and profitability of the company itself.

6. Company-issued options
These are often issued free to staff, especially as part of executive incentive schemes, but can
also be issued at a price, thus raising equity.

They often have a single exercise date or a series of dates and differing exercise prices. They
have also been used as a defence against takeovers or in anticipation of possible future needs
for equity (e.g. in anticipation of the expansion of an existing mine). Investors often value them
because they provide leverage and low risk, as well as ensuring staff are only rewarded for good
performance (by having the exercise price at a level only achievable if the company prospers).
 138 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

7. Partly paid shares

Partly paid shares are an alternative to share options, leaving shareholders with an uncalled
liability rather than a right to exercise to buy a share. This is more onerous on the holders
(such as company staff or executives) and may be attractive as incentives in cases where
options are considered to provide too much of an incentive to risk-taking (a ‘free’ option type
of reward, all upside and limited downside to holders). The uncalled liability is the outstanding
amount that remains payable on a share issue. It is the amount that is yet to be called for by the
issuing company. For example, a company may issue shares at $1.00, with only $0.70 payable
immediately. The balance of $0.30 is an uncalled liability to the holder of the shares.

Hybrids: Equities and securities

MODULE 2

Increasingly over recent years, there have been issues by companies of hybrids, that is, securities
that contain elements of both debt and equity. These securities have taken the form of
convertible notes, preference shares and exchangeable notes.

8. Convertible notes
Convertible notes take many forms, but the main one is the convertible unsecured note.
The convertible note is a debt instrument giving the holder the right to convert to shares at a
future time or to request that the company refund the subscribed amount of funds. If the right
is not exercised, the note is repaid in cash at face value on the maturity date. The interest rate
paid will be lower than current market rates to recognise the benefits of the option to convert
to shares. For the issuer the advantage is the lower interest cost, which is also tax-deductible.
For some investors in convertible notes, the attraction is twofold: income in the form of interest,
plus a potential future capital gain.

Convertible notes also provide some certainty for investors in that the convertible notes give
them a regular income flow. In a number of instances, they enable investors to participate
in a range of issues which the corporation may make during the life of the convertible notes
(e.g. rights issues and bonus issues).

➤➤Question 2.7
Explain why DRPs were and still are popular with investors.

9. Preference shares
These are hybrid securities in the sense that holders receive a ‘fixed’ dividend which is in the
nature of interest, but the shares are also ranked behind debtors if the company is liquidated.
Preference shares may be redeemable or non-redeemable and may also be cumulative or
non‑cumulative with respect to annual payments of any dividend. There is even a category
for zero dividend preference shares (which receive a lump sum dividend on redemption) and
other variations that influence the amount of dividend, timings of payments and options to
redeem shares.

The ability to avoid or defer preference dividends has proved attractive to issuers in times of
financial tightness. For example, following the European sovereign debt crisis of the last few
years, many banks in Europe suspended payment on preference shares as part of their capital
strengthening programs.

Generally, preference shareholders only have votes at general meetings on matters that
affect them.
 Study guide | 139

Preference shares can take a variety of forms:

• Converting preference shares. Enable conversion into ordinary shares at a specified ratio or
at a specified dollar value.
• Cumulative preference shares. Provide that the preference shares carry a specified dividend
rate. If any dividend is missed by the company in any particular year, that ‘missed dividend’ is
added to the dividend which is payable in the next period.
• Participating preference shares. Allow for an additional dividend to be paid above the
specified dividend rate if the dividend to ordinary shareholders is increased.
• Redeemable preference shares. Enable investors to request that their funds be returned at
the expiry of the fixed term.
• Reset preference shares. Provide for a generally fixed percentage rate of return. Where the
rate of return can be adjusted in line with movements in some benchmark interest rate, such

MODULE 2
as the 180-day BBSW or the three-year BBSW plus a margin of between 1 and 2 per cent.

The income to the investor is, in some cases, fully franked and therefore may confer taxation
advantages on investors similar to the benefits provided through dividend imputation on
ordinary shares. Fully franked means that the company which is paying the dividend (on the
preference shares) has paid the full amount of company tax on the underlying income from
which the dividend is paid. Accordingly, investors can claim a credit for tax which has been paid
by the company.

10. Exchangeable notes

Exchangeable notes bear many of the characteristics of convertible notes except that they are
issued not by the principal corporation, but by a third party. However, the issuer is responsible for
facilitating the conversion of the notes into ordinary securities at a particular time in the future.

Reason for the issue of hybrid securities

Banks are particularly attracted to this form of security for two reasons. Firstly it can be classified
as ‘tier one’ capital under the Basel capital requirements. Secondly it allows them to distribute
franking credits (via the dividend payments of the hybrid) earlier than would otherwise be
possible (in view of prudential banking practice often not distributing all its profits and franking
credits in any given year).

An Australian example is the Commonwealth Bank (CBA) hybrid security entitled ‘Perpetual
Exchangeable Resaleable Listed Securities’ (PERLS). This hybrid provided investors with a rate
of return or income each year, related to the prevailing bank bill rate plus a fixed percentage
above that rate. The PERLS security was originally issued at a margin of 3.4 per cent per annum
above the BBSW which at that time was 3.3 per cent per annum. Accordingly, at the time of issue
this provided an equivalent unfranked distribution rate of 6.68 per cent per annum, which was
significantly higher than that available on either bank bills or term deposits (around 5%).

A significant feature of this form of hybrid security is that the income can be delivered to the
investor on a fully franked basis. The mechanism by which this occurs is that the corporate
tax rate is applied to the distribution rate of 6.68 per cent (less the company tax rate of 30%,
(i.e. 6.68% multiplied by 0.7)) to provide a fully franked distribution rate to investors of
4.676 per cent which was attractive at the time of issue. Moreover, because the rate of return
on the hybrids varies in accordance with the bank bill rate, the rate of return would increase
if interest rates increased.

In recent years all four of Australia’s major banks have issued one or more varieties of hybrid
securities. These include perpetual rate notes, convertible preference shares and re-set
preference shares. All involve franking/no franking, conversion/no conversion of the underlying
shares at a specified date, or a floating/fixed interest rate which is adjusted at specified intervals.
 140 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Implications for funding and capital management planning

Financial risk management will require the organisation’s board to approve the business’s liquidity
risk appetite, capital plan and approach to managing potential periods of financial constraints—
whether externally or internally generated. The chief financial officer then oversees and manages
the reporting for key metrics.

Four areas in particular need board approval:

1. the permissible level of gearing within the organisation—and policies to correct any decline
towards unacceptable levels;
2. a long-term plan to refinance the company; one year of planning is insufficient if there is a
cyclical downturn;
3. the level and form of stand-by sources of financing, especially short-term liquidity needs; and
MODULE 2

4. exit strategies if required—similar in nature to those outlined in the section ‘Bank loan
assessment and management’ earlier in this module.
 Study guide | 141

Part D: F
 unding for specific types of
business structures
Funding for sole traders and partnerships
Two of the biggest difficulties facing sole traders are sourcing adequate capital to commence
business and then sourcing regular finance to expand and develop the business. The inability
to raise funds external to the business itself is one of the major factors hampering the growth of
many sole traders. As most funding sourced by sole traders is by way of loans, sole traders are

MODULE 2
placed in a precarious situation should there be a downturn in the level of economic activity as
debt servicing becomes a critical strain on available cash balances.

In summary, while sole traders enjoy all the benefits when their enterprise is successful, including
any profits, their business remains very vulnerable to the ebbs and flows of the business cycle and
may require expansion into a partnership.

Partnerships enable the burden of funding to be spread among a number of individuals.

Conversely, profits of the enterprise need to be split between the various partners. There are
also legal ramifications; for a standard partnership, each partner is legally liable for the debts,
obligations and liabilities of the partnership—and, further, while the partnership does not pay tax,
the partners do.

A more recent development has been the introduction of the concept of an incorporated
partnership under which the liability of the partners can be limited. This is similar to a limitation
on the liability which attaches to incorporated enterprises, such as corporations, where liability
of shareholders is limited to the amount investors pay on fully paid ordinary shares. Incorporated
partnerships are now a common feature of legal and accounting organisations.

Apart from private sources, there are some other major sources of funding for sole traders
and partnerships.

The first source is the business itself. Some assets (stock) can be turned into flows—such as
sale and leaseback, factoring or forfeiting of property sold and rental property used instead.

The second source is external loans. These can take several forms, but the most common are a
bank loan or bank overdraft. A bank loan provides a longer-term type of finance (e.g. five years),
although some security is normally required, often in the form of personal guarantees provided
by the partner. Bank loans are good for financing investment in fixed assets and are generally at a
lower rate of interest than a bank overdraft.

A bank overdraft is a more short-term type of finance which is also widely used by start-ups and
small businesses. An overdraft is a type of loan facility, but normally its flexibility over a straight
loan comes at the cost of higher interest rates. An overdraft is a flexible source of finance, in the
sense that it is only used when needed.

The third source is a line of credit from suppliers or similar stakeholders. This is often possible
where the other parties recognise the longer-term benefits of short-term financial support.

Another source is government funding, especially for businesses such as indigenous, rural and
export-oriented organisations. Government grants are a major expenditure item on all state
and federal budgets and also extend to items such as insurance (for example, in Australia the
Export Finance Insurance Corporation, EFIC).
 142 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Yet another source is outside investors—individuals outside the family who are willing to inject
capital, expertise or other assets (such as premises) into the business. They may also provide
technical help, such as systems, accounting and tax services. These outside investors often make
their own skills, experience and contacts available to the company and should be distinguished
from venture capitalists (private equity providers), which are discussed in the next section.

Funding for private companies and other small

to medium enterprises (SMEs)
The process for the establishment and conduct of both private companies and public
MODULE 2

corporations is set out in extensive detail in the Corporations Act 2001 (Cwlth). The Corporations
Act is the result of Australia’s states and territories agreeing to uniform laws, which apply to
corporations. The options available for fundraising by corporations are much wider than those
available to sole traders and partnerships. Public corporations have the opportunity of raising
equity, arranging for debt financing and raising funds through hybrids (referred to in the section
‘Hybrids: Equities and securities’).

As defined by the Corporations Act 2001 (Cwlth), a private company is one that is registered as, or
converts to, a proprietary company under the Act. Under this statute, a proprietary company must:
• be limited by shares or be an unlimited company with a share capital;
• have no more than 50 non-employee shareholders;
• not withhold information or do anything that would require disclosure to investors under
Chapter 6D of the Act; and
• have at least one director.

With up to 50 non-employee shareholders and the ability to have employees as owners as well,
the scope for equity capital widens greatly. Further, it gives access to other specialised forms of
capital. One of these is venture capital, also known as private equity. Venture capitalists rarely
invest in small businesses (their minimum investment is usually over AUD 1 million, often much
more). They prefer to invest in businesses which have established themselves and, while often
providing excellent access to financial resources, they expect high returns for their perceived
high risks.

Unlisted public companies

Unlisted public companies differ from proprietary companies in that they can offer shares
to the public. However, in contrast to a listed public company, their shares will not be included
on the official list of a securities exchange. They include:
• public companies limited by shares (not listed);
• unlimited public companies; and
• unlisted no liability companies (mining companies).

All unlisted public companies registered under the Corporations Act 2001 (Cwlth) must have at
least three directors, two of whom must be Australian residents.

Public companies limited by guarantee and not-for-profit organisations

Public companies limited by guarantee are a common structure for not-for-profit or charitable
organisations that reinvest any surplus (profit) and where the liability of members is limited to
the amount they agree to contribute in the event the company is wound up. This is typically a
nominal amount and is prescribed in a company’s constitution. As public companies limited by
guarantee are registered under the Corporations Act 2001 (Cwlth), directors of not-for-profits
(which have this structure) generally have the same legal duties, responsibilities and liabilities as
directors of commercial entities that are public companies registered under the Act.
 Study guide | 143

These organisations can tap into the resources of members and also, under government
regulations, have some access to the public through appeals and similar fund-raising
opportunities.

Public companies
Requirements for entities wishing to list on the ASX
For entities wishing to list on the ASX, a number of conditions and tests must be met to the
satisfaction of the ASX (ASX 2014b).

MODULE 2
Among the 17 conditions referred to in ASX Listing Rule 1.1, three are of particular significance:
• Condition 1A—‘the entity must have a constitution’.
• Condition 3—‘a prospectus or product disclosure statement must be issued and lodged
with ASIC’.
• Condition 7 requires an entity to satisfy one of (a), (b) or (c):
(a) that there be ‘at least 400 holders each having a parcel of the main class of securities
with a value of at least $2000’; or
(b) that there be ‘at least 350 holders each having a parcel of the main class of securities
with a value of at least $2000’ and ‘persons who are not related parties of the entity
must hold that number of securities in the main class, excluding “restricted securities”,
which is not less than 25 per cent of the total number of securities in that class’; or
(c) that there be ‘at least 300 holders each having a parcel of the main class of securities
with a value of at least $2000’ and ‘persons who are not related parties of the entity
must hold that number of securities in the main class, excluding “restricted securities”,
which is not less than 50 per cent of the total number of securities in that class’.

Also, there are two main tests which have to be satisfied by an entity seeking a listing on the
ASX—the profits test and the assets test.

Profit test (ASX Listing Rule 1.2)

To satisfy this rule:
• the entity must have aggregated profit from continuing operations for the last three financial
years of $1 million in total (Listing Rule 1.2.4);
• ‘the entity’s consolidated profit from continuing operations for the 12 months to a date not
more than two months before the date the entity applied for admission’ for listing on the ASX
‘must exceed $400 000’ (Listing Rule 1.2.5); and
• the entity must give the ASX ‘a statement from all directors … confirming that they have
made enquiries and nothing has come to their attention to suggest that the economic entity
is not continuing to earn profit from continuing operations up to the date of application’
(Listing Rule 1.2.5A).

Assets test (ASX Listing Rule 1.3)

An entity ‘must have net tangible assets of at least $3 million after deducting the cost of fund
raising or a market capitalisation of at least $10 million’ (Listing Rule 1.3.1).

In the case of an ‘investment entity’ there need to be ‘net tangible assets of at least $15 million
after deducting costs of fundraising’, or the entity ‘must be a pooled development fund and have
net tangible assets of at least $2 million after deducting cost of fundraising’ (Listing Rule 1.3.1A).
 144 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

With regards to its total tangible assets, either:

• ‘less than half the entity’s total tangible assets must be cash or in a form readily converted to
cash’; or
• the entity ‘has a commitment consistent with its company objectives to spend at least half
of its cash and assets in a form readily convertible to cash’ (Listing Rule 1.3.2).

With regards to working capital, the entity must have enough working capital to carry out its
stated objectives, and otherwise at least $1.5 million (Listing Rule 1.3.3).

Furthermore, the issue price or sale price of all the securities for which the entity seeks quotation
must be at least 20 cents in cash (Rule 2.1, Condition 2).
MODULE 2

Advantages and disadvantages of listing on the ASX

Advantages
• One of the major advantages of a company listing on the stock exchange relates to it being
able to increase its overall profile in the corporate and general community.
• A higher profile means that the company is normally better able to obtain and retain
employees.
• A listed company can provide its employees with shares in the company as incentives and
rewards for contributing to the profitability of the enterprise.
• There is a continuous marketplace for investors to buy and sell shares in the entity—that is,
the value can be readily obtained at any one time.
• It is easier for the company to raise additional capital when investors can readily see the value
of the company at any particular time.

Disadvantages
• The cost of obtaining listing on the ASX can be significant, especially for smaller companies.
These costs include stock exchange fees, as well as fees for managers, underwriters and
other finance company experts who may be required to make inputs into the preparation for
listing, preparation of the prospectus or information memorandum.
• The company must have a sufficient spread of shareholders (i.e. 400—each holding a parcel
of at least $2000).
• Original owners of the entity may have their equity diluted if other investors are permitted to
obtain shares in the listed entity, or the original owners may lose control of what hitherto may
have been family ventures. (This was one of the main drawbacks of the second board market
companies.)
• Entities face stringent disclosure requirements according to the rules of the ASX, the most
important of which is the requirement for entities to make continuous disclosure of any
information which may have a material impact on the share price of the corporation.
• Other reporting requirements include the provision of half-yearly and yearly reports.
Exploration companies and mining companies are required to submit quarterly production
reports as a minimum reporting requirement.
• Directors of publicly listed entities are more in the public eye than are directors of non-listed
entities. However, directors of listed and non-listed entities have the same duty of care at
all times to act with the utmost good faith in the interest of the owners of the entities—
the shareholders.

➤➤Question 2.8
Explain the three critical conditions and two tests which entities must satisfy in order to obtain
listing on the ASX.
 Study guide | 145

Part E: Legal requirements for raising

funds from the public
Pre-float preparations
Private companies frequently reach a stage where the financing of further growth is beyond
the financial capacity or appetite of existing equity owners of a business. When this point is
reached, one solution is to raise equity funding from the public through a prospectus (as a legally
sanctioned public offering) to enable the business to expand its operations or its pool of working

MODULE 2
capital or indeed to reduce its leverage or borrowings. By doing so the company establishes a
broader market for its securities with a widened pool of potential and actual investors.

There are some requirements that should be completed prior to considering a float.

Most private companies have share structures that are inappropriate for seeking access to public
financing. This is because they usually have many classes of shares with different rights, with the
likelihood that the number of shares on issue is small and does not lend itself to broad and deep
market trading. It is therefore normal for a company to reorganise its capital structure in such
a way as to provide sufficient shares for one tradeable class of shares that has a unit value that
lends itself to ease of purchase and resale.

In addition to a reorganisation of the company’s capital structure, there is also the need for
a detailed audit to be undertaken of the company’s various metrics, including its financial
statement of position, cash flow/profit projections, an analysis of its operations, technical
assessments of service, licences and contractual obligations. More qualitative appraisals should
also be completed on the company’s key staff, management structure and board of directors.
In addition, an appraisal should be undertaken of the company’s selected and extended
network of trusted advisors and supporting administrators. This appraisal should be supported
by any required tax and legal advice. The broad aim of this evaluation or appraisal is that it
will ultimately form the basis of the prospectus offering to the public.

Australia
Corporations wishing to raise funds from the public are required to issue a prospectus under
s. 709 of the Corporations Act 2001 (Cwlth). Section 710 of the Act requires that the prospectus
must contain all the information that investors and professional advisers would reasonably require
to make an informed assessment, including details of the assets and liabilities, financial position,
performance, profits, losses and prospects for the body that is to raise the funds.

However, there is an exemption for offers of securities to sophisticated investors. Subsection 708(8)
provides that an offer of securities does not need disclosure to investors where the minimum
amount payable for securities on acceptance of the offer by the person to whom the offer is made
is at least $500 000.

Whenever a corporation wishes to seek funds from investors, there is a requirement that the
corporation issue a prospectus, except where it is a ‘placement’. This section needs to be seen
in conjunction with ASX Listing Rule 7.1, which requires that no more than 15 per cent of a
company’s value can be issued without the need to issue a prospectus (or indeed make a pro rata
issue to all security holders).
 146 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

In general, proprietary limited companies will be precluded from making issues to the public
because they are not permitted to have more than 50 non-employee shareholders.

Accordingly, if a proprietary limited company wished to make an offer to the public, it would need
to comply with the prospectus provisions of the Corporations Act which require prospectuses
in all cases, except where investors subscribe more than $500 000 each. However, it should be
noted that while proprietary limited companies are not precluded from listing on the ASX, the ASX
requirement that there must be at least 300 shareholders subscribing an amount of $2000 each
makes it difficult for them to obtain listing, as proprietary limited companies are not permitted to
have more than 50 non-employee shareholders—the proprietary limited company would have
to have up to 50 non-employee shareholders and 250 or more employee shareholders to meet the
requirement of having at least 300 shareholders.
MODULE 2

Apart from the requirements of the Corporations Act, companies listing on the ASX are also
required to comply with the listing rules prescribed by the exchange. Chapter 19 of the listing
rules sets out the principles on which they are based. These principles establish minimum
standards of quality, size, operation and disclosure and in so doing attempt to ensure that:
• there is sufficient investor interest;
• securities are issued in circumstances which are fair;
• the rights and obligations attaching to securities are fair to new and existing holders;
• there is timely disclosure of information;
• practices must be adopted and pursued which protect the interest of security holders;
• security holders must be consulted on matters of significance; and
• market transactions must be commercially certain.

In addition, the rules attempt to ensure that information supplied by companies is of the highest
standard. The rules require that the highest standard of integrity, accountability and responsibility
of entities and their officers must be maintained.

The main rule in relation to disclosure is contained at Listing Rule 3.1. It states that, ‘once an
entity is or becomes aware of any information concerning it, that a reasonable person would
expect to have a material effect on the price or value of the entity’s securities, the entity must
immediately tell ASX that information’.

In addition to the continuous disclosure requirements, each listed company is required to provide
reports for the end of the half-year and financial year of the listed entity, and the entity must
provide this information within 60 days of the end of the period to which the report applies.
Mining and exploration companies have additional reporting requirements, as set down in
Listing Rule 5.6. Companies are required to provide a statement relating to exploration results,
mineral resources or reserves in relation to their mining tenements.

Offshore capital raising

Offshore borrowings and equity capital raisings normally have to conform to the legal
requirements of the country in which the funds are raised. Sometimes this results in considerably
onerous requirements and expensive costs of issuing and managing the capital raisings.

Equity raisings in Hong Kong, for instance, are done on the Hong Kong Stock exchange.
The Hong Kong Stock exchange prescribes significant pre- and post-listing requirements in
order to list on its exchange, including the allowed listing methods, requirements, processes
and schedule of fees plus listing fee and reporting obligations to remain listed on Asia’s third
largest exchange after Tokyo and Shanghai. It is regulated by the Hong Kong Securities and
Futures commission. As an alternative and rival, Singapore also has an equivalent exchange,
the Singapore Exchange (SGX) which operates along similar lines and is regulated by the
Monetary Authority of Singapore.
 Study guide | 147

An example of how an offshore borrowing and capital raising takes place and the types of
management, administrative and legal matters encountered, can be illustrated by using the
example of a capital raising in the Samurai bond market.

‘Samurai bonds’ are bonds which are issued by foreigners into the Japanese money markets
and have the following characteristics:
• Japanese law–governed debt securities;
• denominated in Japanese yen;
• publicly offered on a primary basis;
• issued by a non-Japanese issuer;
• mainly targeting Japanese institutional investors; and
• normally non-guaranteed straight bonds and not listed.

MODULE 2
Samurai bonds are dematerialised in that they have no paper issue and are electronically settled
through the Japan Securities Depositary Center, Inc. (‘JASDEC’, the Japanese equivalent of
Euroclear—one of the principal clearing houses for securities traded in the euro-market).

Any proposed offer of samurai bonds must be made with the Japanese regulatory authorities
and rulings are prescribed by the applicable Japanese laws. Disclosure requirements are more
rigorous than in the Australian markets. However, since 2012 non-Japanese issuers can file
a Foreign Company Securities Registration Statement (SRS) partly in English, instead of an
all‑Japanese SRS, which significantly reduces the administrative overheads.

A Foreign Company SRS consists of (a) the securities information in Japanese and (b) the issuer’s
continuous disclosure documents in English (such as annual or interim reports) or offering
documents in English. ‘English documents’ means information on the issuer’s (i) business
activities, (ii) key financial information over the most recent five years; and (iii) a prescribed set
of risk factor metrics, disclosed in Japanese in order to protect the public investors.

After the expiry of a year from the date of a public offering in Japan (of samurai bonds or
otherwise), the issuer becomes eligible, provided that certain other criteria are met, to establish a
Japanese shelf program and issue samurai bonds thereunder in a speedier and more flexible way.

In addition to the requisite securities filing, a prospectus must be prepared, printed and delivered
to the investors in connection with each offering.

The terms and conditions are very much standardised in the samurai market, but certain terms
such as the negative pledge and events of default, can be drafted to conform with the issuer’s
existing debt issuance documentation.

A subscription agreement will be entered into by the issuer and the managers who underwrite
the samurai bonds.

Samurai bonds may be issued to institutional or retail investors. Usually, samurai bonds are
offered to institutional investors and denominated at 100 million Japanese yen per bond.
Continuous disclosure obligations are also enforced, even though samurai bonds are typically
not listed.

In contrast, the euro-yen market requires no Japanese documentation, is not liable to Japanese
withholding tax and presently has far fewer disclosure requirements (although this may change).

However, the European sovereign debt crisis has triggered a wide-ranging set of national reviews
that now put far greater onus on issuers to control the offerings they issue and to ensure all legal
requirements are met.
 148 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Review
An essential part of the finance function is the procurement and management of funds.
This module presented an introduction to the debt and equity funding alternatives available
to companies and an overview of cash flow and working capital management.

Raising initial funds, refinancing operations and managing working capital and liquidity have
always been key issues for management, but the spiking of risk of default and subsequent losses
on default, combined with de-leveraging of public and private sector organisations over the
years since the GFC and European sovereign debt crises mean that this area will remain a critical
one for companies and governments for the foreseeable future.
MODULE 2

Module 3 extends the discussion by considering the appropriate mix of debt to equity in the
capital structure and the evaluation of long-term investments.
 Suggested answers | 149

Suggested answers
Suggested answers

MODULE 2
Question 2.1
The company’s current ratio is 3.5, so its current liabilities can be computed as follows:

Current ratio = 3.5 = Current assets / Current liabilities

3.5 = 5 250 000 / Current liabilities

Current liabilities = 5 250 000 / 3.5 = $1 500 000

Since the increase in the inventory base is financed with (short-term) borrowed funds, the change
in inventories equals the change in current liabilities. Letting the change in inventories be X,
and using the target current ratio of 2.5, we can compute the maximum change in inventories
before the target ratio is reached as follows:

Target current ratio = 2.5 = (5 250 000 + X) / (1 500 000 + X)

Multiplying both sides by (1 500 000 + X):

2.5 × (1 500 000 + X) = (5 250 000 + X)

Multiplying out the left-hand side:

3 750 000 + 2.5X = 5 250 000 + X

Subtracting X from both sides:

3 750 000 + 1.5X = 5 250 000

 150 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Subtracting 3 750 000 from both sides:

1.5X = 5 250 000 – 3 750 000

1.5X = 1 500 000

X = $1 000 000

The change in inventories is therefore $1 000 000.

Question 2.2
MODULE 2

From information in Example 2.1, the accounts receivable for Herb Ltd (Herb) are $20 000,
and for Shrub Ltd (Shrub) are $20 000. The accounts payable for Herb are $50 000, and for Shrub
are $90 000.

The accounts receivable periods for Herb and Shrub are:

Herb’s accounts receivable period = 20 / (120 / 365) = 60.8 days

Shrub’s accounts receivable period = 20 / (150 / 365) = 48.7 days

The accounts payable periods for Herb and Shrub are:

Herb’s accounts payable period = 50 / (80.4 / 365) = 227.0 days

Shrub’s accounts payable period = 90 / (127.5 / 365) = 257.6 days

Herb’s accounts receivable period is 61 days which is much higher than Shrub’s accounts
receivable period at 49 days. This indicates that Shrub is managing its accounts receivables
better by collecting them more promptly than Herb. It could also indicate that Herb is facing
problems collecting cash from its customers. The accounts payable periods for both companies
are quite similar in that they are both well outside normal operating conditions of 60–90 days.
This could indicate an inability to pay debts as they fall due, and such extended delays in
payments can also lead to reputational damage with suppliers.

Question 2.3
The three key terms or conditions missing from the memorandum are as follows.

1. Benchmark for the interest rate: normally the three, six or 12-month bank bill swap rate
(BBSW) for Australian loans by banks to domestic companies.

2. Margin above benchmark: normally quoted in basis points, such as 45 bp above BBSW—
meaning 0.45 per cent above the current relevant BBSW. If the three-month BBSW rate was
the benchmark and it was 4 per cent per annum then the loan rate would be 4.45 per cent
per annum, payable quarterly.

3. Date of drawdown: normally a specific date, but a range may be specified, such as
‘not before xx July 201X with three business days’ clear notice of requirement for funds’.

Other terms and conditions may also be required but the key terms are that the loan must be
clearly priced and timings set.
 Suggested answers | 151

Question 2. 4
The loan would be declined.

As shown in Table 2.2, Megabank specifically declines lending to applicants rated BBB– or lower.

This would occur regardless of the apparent profitability of Hyperactive Ltd.

Question 2.5

MODULE 2
(a) A large retail chain might use commercial bills, bank borrowings and trade credit to finance
its inventory and debtors. It may use leasing and bank borrowing to finance its premises,
fixtures and fittings.

(b) A new car dealer might use finance company borrowing or commercial bills to finance its
inventory, a wholesale or floor stock plan financing arrangement to finance its floor stock,
and bank borrowing to finance its other working capital. It may also lease its premises.

(c) A suburban furniture store might also use finance company borrowing or commercial bills to
finance its inventory and bank borrowing to finance its other working capital.

(d) A manufacturer may use bank borrowing, parent-company loans and commercial bills to
finance its short-term needs. It may also use a subsidiary finance company to finance stock
held in dealers’ premises.

Question 2.6
(a) A domestic bond is held by investors in the issuer’s own country and is denominated in the
domestic currency. For example, an Australian company issues bonds to Australian resident
investors in Australian dollars.

(b) A foreign bond is issued by a domestic borrower to an investor in a country other than the
borrower’s country and is denominated in the investor’s currency. For example, an Australian
borrower raising funds denominated in Singapore dollars in Singapore, or a Japanese
borrower raising US dollar denominated funds in the US market.

(c) A Eurobond is a bond denominated in a currency and is issued to investors outside the
domicile of the currency of issue. For example, a Japanese borrower issuing US dollar
denominated bonds to investors domiciled in the UK and Europe.

There are several factors that influence the decision on what type of bond to issue. These include
the company’s financing needs, the financing costs faced in different markets, its credit rating and
its desire to establish a presence in overseas capital markets or reduce tax. Consideration should
also be given to the existence of ‘natural’ hedges. For example, a company exposed to Japanese
yen may naturally offset this exposure by borrowing in yen via a euro-yen bond issue or by issuing
yen-denominated foreign bonds in Japan.
 152 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Question 2.7
Dividend reinvestment plans (DRPs) have been and are still popular for a number of reasons.
First, they are a simple and efficient way for listed companies to raise capital without the
associated logistical, administrative and regulatory difficulties associated with placements and
rights issues. Second, it is difficult for companies to raise funds when the sharemarket is in a
bearish period as it was during the late 1980s and early 1990s. In such a market it is often very
expensive to raise funds, as companies have to issue more shares to raise a given amount of
capital. Third, DRPs provide a means of distributing the franking credits associated with dividend
payments to shareholders without the need to actually pay these dividends as would be required
with cash dividends. In contrast, DRPs used to appeal to investors as the shares were usually
issued at a discount and some investors preferred not to automatically receive two dividend cash
MODULE 2

payments every year. Accordingly, there has been a large proportionate rise in the amount of
funds raised through DRPs since the early 1990s.

Question 2.8
Three of the conditions required to be met by entities seeking listing are that:
1. the entity has a constitution;
2. the entity has a prospectus or product disclosure statements must be issued and lodged
with ASIC; and
3. (a) there be at least 400 shareholders each having a parcel in the main class of securities
with a value of at least AUD 2000, or
(b) there be at least 350 shareholders holding AUD 2000 worth of shares, but persons who
are not related parties of the entity seeking listing must hold not less than 25 per cent of
the total number of securities of that class which is being quoted for listing; or
(c) there be at least 300 shareholders holding AUD 2000 worth of shares, but persons who
are not related parties of the entity seeking listing must hold not less than 50 per cent
of the total number of securities of that class which is being quoted for listing.

The two tests which must be satisfied relate to the profit and asset tests.

The profit test requires an entity to have aggregated profits from continuing operations for the
last three financial years of AUD 1 million in total and a profit in the last year of AUD 400 000,
and to give the ASX a statement from all directors confirming that the entity is continuing to earn
profits from continuing operations.

The asset test requires the entity to have tangible assets of at least AUD 3 million or a market
capitalisation of at least AUD 10 million. Note that in the case of an investment entity there needs
to be net tangible assets of at least AUD 15 million after deducting costs of fundraising, or the
entity must be a pooled development fund and have net tangible assets of at least AUD 2 million
after deducting the cost of fundraising. There are additional requirements for tangible assets
(less than half being cash) and working capital (at least $1.5 million).
 References | 153

References
References

MODULE 2
ASX (Australian Securities Exchange) 2014a, ASX Annual Report 2014, accessed October 2014,
http://www.asx.com.au/documents/asx-news/ASX_Ltd_Full-Year_Results_Annual_Report_
August_2014.pdf.

ASX (Australian Securities Exchange) 2014b, ASX Listing Rules, accessed August 2014,
http://www.asx.com.au/regulation/rules/asx-listing-rules.htm.

BHP Billiton 2007–2012, Annual Reports, BHP Billiton, Melbourne.

Copeland, T., Coller, T. & Murrin, J. 1996, Valuation—Measuring and Managing the Value of
Companies, 5th edn, Wiley, New York.

Debelle, G. 2011, ‘The Australian bond market in 2011 and beyond’, KangaNews Australian DCM
Summit, Sydney, 15 March.

Debelle, G. 2012, ‘Enhancing Information on Securitisation’, Address to Australian Securitisation

Forum, Sydney, 22 October, accessed June 2014, http://www.rba.gov.au/speeches/2012/.html.

RBA (Reserve Bank of Australia) 2014a, The Australian Economy and Financial Markets Chart Pack
June 2014, RBA, Sydney, accessed June 2014, http://www.rba.gov.au/chart-pack/pdf/
chart-pack.pdf.

RBA (Reserve Bank of Australia) 2014b, ‘Opportunities and challenges for market-based
financing’, Speech to the ASIC Annual Forum 2014, Phillip Lowe, 25 March, accessed August
2014, http://www.rba.gov.au/speeches/2014/sp-dg-250314.html.

World Federation of Exchanges 2009, ‘Domestic market capitalization’, WFE, December,

accessed October 2013, http://www.world-exchanges.org/statistics.

Wikipedia 2012, ‘Bond (finance)’, accessed October 2013, http://www.en.wikipedia.org/wiki/

Bond_(finance).
 154 | MANAGEMENT OF LIQUIDITY, DEBT AND EQUITY

Optional reading
Australian Financial Markets Association 2013, 2013 Australian Financial Markets Report, AFMA,
accessed August 2014, http://www.afma.com.au/afmawr/_assets/main/lib90013/2013%20afmr.pdf.

Basel Committee on Banking Supervision, accessed October 2013, http://www.bis.org/bcbs.

Basel Committee on Banking Supervision, ‘International regulatory framework for banks

(Basel III)’, accessed October 2013, http://www.bis.org/bcbs/basel3.htm.

McLure, B. 2010, ‘Free cash flow: Free, but not always easy’, Investopedia, accessed October
2013, http://www.investopedia.com/articles/fundamental/03/091703.asp.
MODULE 2

Petty, J. W., Keown, A. J., Scott, D. F., Martin, J. D., Burrow, M., Martin, P. & Nguyen, H. 2012,
Financial Management: Principles and Applications, 6th edn, Pearson, Sydney.

Weston, J. F., Mitchell, M. L. & Mulherin, J. H. 2003, Takeovers, Restructuring, and Corporate
Governance, 4th edn, Pearson, Sydney.
 FINANCIAL RISK MANAGEMENT

Module 3
INVESTMENT EVALUATION AND
CAPITAL STRUCTURE
ASJEET S. LAMBA
 156 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Contents
Preview 157
Introduction
Objectives
Value, time and risk

Part A: Capital budgeting techniques 160

Accounting rate of return 161
Payback period 162
Net present value 163
Internal rate of return 163
NPV and IRR methods compared 166
Mutually exclusive projects with different lives 170

Part B: Cost of capital and capital structure 173

Qualitative factors 173
Quantitative factors 174
Cost of debt
MODULE 3

Cost of equity
Capital asset pricing model
CAPM: Practical issues
Cost of preference shares
Weighted average cost of capital 182
WACC with taxes 185
Before-tax WACC
After-tax WACC under the classical tax system
After-tax WACC under the imputation tax system

Part C: Additional issues in capital budgeting 189

Estimating cash flows 189
Inflation and capital budgeting 191
Impact of inflation on the cost of funds
Impact of inflation on cash flows
The adjusted present value approach 195

Case studies 197

Review 199

Appendix 201
Appendix 3.1 201

Suggested answers 213

References 223
 Study guide | 157

Module 3:
Investment evaluation
and capital structure
Study guide

MODULE 3
Preview
Introduction
In Module 2 we discussed the various sources of funds available to a finance manager when
considering an organisation’s financing alternatives. The objective of this module is to develop
an understanding of how an organisation should allocate available funds to various long-term
investment opportunities. A related issue is the requirement that the organisation maintain an
appropriate funding mix to ensure that its operations are financed at acceptable cost and risk
levels. These considerations are fundamental to an understanding of financial risk management.

As outlined in Module 1, the Financial Risk Management (FRM) subject is designed to equip you
to identify and manage the financial risks associated with organisations in order to maximise their
long-term value. It is in the context of this objective that organisations make financial decisions
which can be grouped into the following three broad categories:
1. The investment or capital budgeting decision, which relates to the manner in which funds
raised are put to productive use in investment opportunities.
2. The financing or capital structure decision, which relates to the types of funds raised in the
form of debt, equity, and hybrid securities to finance its investment opportunities.
3. In the case of a company, the dividend policy decision, which relates to the form in which
returns on investments are distributed to investors.

Clearly, the three decisions are interrelated. For example, the investment decision cannot
be made until the financing decision has been resolved. The financing decision, in turn,
has implications for the dividend policy decision, and vice versa.
 158 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

The key implication of the shareholder wealth-maximisation objective is that each of these
decisions is made on the basis of what adds most value to a company. For example, if a certain
mix of debt and equity makes a company more attractive to investors than other financing
combinations, the company would be expected to adopt this capital structure subject to the
board’s risk appetite. In relation to the investment decision, it would be expected that a company
would allocate funds to investment projects that generate the highest return.

The focus of this module is the investment and financing decisions. Also of importance is
the decision process relating to investment in current assets. This area of working capital
management was discussed in Module 2. Note that the dividend policy decision is not covered
in this subject.

An understanding of financial mathematics is required in this module, as many of the techniques

that are introduced here involve financial calculations. Given this requirement, you should
first review the financial mathematics concepts and applications included in the appendix to
this module.

The booklet Project Evaluation is provided on My Online Learning for your use in conjunction with
this module. The booklet is designed to enhance your understanding of this module and will also
MODULE 3

be examinable.

Objectives
At the end of this module you should be able to:
• identify and apply the capital budgeting techniques used in project evaluation;
• explain why investment decisions should be analysed using the net present value (NPV)
method, and apply it to various investment project scenarios;
• discuss how capital structures are determined using a simplified structure of debt, equity and
preference shares;
• calculate the cost of debt, equity and preference shares and explain the capital asset pricing
model (CAPM);
• calculate and use the before- and after-tax weighted average cost of capital (WACC); and
• discuss the impact of project cash flows, inflation and the adjusted present value approach on
the capital budgeting process.

Value, time and risk

An organisation’s financing and investment decisions are subject to the following two overriding
considerations.

• Money has a time value. Under this principle, a dollar received today is worth more than
a dollar to be received in the future. This is because the opportunity of earning interest
is forgone if money is received at some future date rather than today. Money has an
opportunity cost which is typically measured using the rate of interest currently offered in
financial markets.

• Risk. Risk exists where there is a possibility that actual outcomes will vary from what was
expected. A basic principle of finance is that the expected return should be directly related
to the level of risk borne. Accordingly, the greater the risk involved in a course of action, the
higher will be the expected (or required) return.
 Study guide | 159

As discussed throughout this study guide, the two major dimensions of risk that affect a
company’s investment and financing decisions are:
–– Business or operational risk, which is the risk arising from an organisation’s investment
decisions. Business risk is reflected in the variability of operating income (that is, earnings
before interest and tax), and depends on the relationship between the operating income
expected from an organisation’s assets and general economic conditions. That is,
it essentially encompasses the inherent risk of an organisation’s business activities.
–– Financial risk, which refers to the variability in net income that arises from an
organisation’s financing decisions. In general, the higher the proportion of debt finance
employed, the greater will be the variability of returns to shareholders and, hence,
the higher the degree of financial risk. Financial risk has various components, including
interest rate risk and currency risk, which are discussed in detail in Modules 5 and 6.

Note also that these two sources of risk are related—business risk arises from the asset side of the
statement of financial position, while financial risk is determined by how those assets are financed,
as indicated by the organisation’s liability structure. While financial risk management is primarily
concerned with the liabilities side, decisions about financing are closely linked with decisions
about investments and cannot be ignored. These interactions, however, are beyond the scope of
this module.

MODULE 3
This module considers issues relating to both investment and financing decisions, with a greater
focus on investment decisions. We cover the investment (or capital budgeting) decision in Part A
and focus on the issues related to the financing (or capital structure) decision in Part B. In Part C
we examine some additional issues related to capital budgeting.
 160 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Part A: Capital budgeting techniques

In a report entitled Project Appraisal Using Discounted Cash Flow, the International Federation
of Accountants (2008) recommends that the following major principles be adhered to when
appraising investment projects using the discounted cash flow method:
1. When appraising multi-period investments the time value of money should be taken into
account and this time value should reflect the company’s opportunity cost of capital.
2. The discount rate used to estimate a project’s net present value should reflect the project’s
systematic risk and not the systematic risk of the company undertaking the project.
3. The discounted cash flow method should only consider the incremental cash inflows and
outflows associated with a project. In this context, cash outflows incurred in the past should
not be considered as these are not incremental costs related to the future of the project.
4. All assumptions underlying the discounted cash flow analysis should be supported by
reasoned judgment, especially where the relevant variables are difficult or problematic to
estimate. This can be done using sensitivity analysis to identify key variables and risks which
reflect the most likely, worst and best case scenarios.
5. A post-completion audit of an investment decision should include an assessment of the
decision-making process and the main outcomes associated with the investment decision.
MODULE 3

This module closely follows the recommendations above and focuses in particular on principles
1 to 3.

When an organisation allocates funding to long-term investments, the outlay is made in the
expectation of future benefits in the form of future cash flows. The most common examples of
long-term investments are the purchase of new assets or replacement of manufacturing plant
or equipment. In making the decision to invest in these opportunities, the key consideration
in evaluating the proposal is whether or not it provides an adequate return to shareholders.
This evaluation process is known as project evaluation or the capital budgeting decision.

The capital budgeting decision can be viewed as a five-step process.

Step 1: Generation of investment proposals

Typically, managers of production or manufacturing divisions will identify the need for a capital
investment, and will communicate this to the finance department.

Step 2: Estimation of future cash flows for the proposals

The manager who generated the investment proposal will also be involved in this step of
the process, sometimes working with the finance manager.

Step 3: Evaluation of the future cash flows

In this step, the finance manager will apply capital budgeting techniques to determine whether
or not the project under consideration should be accepted.

Step 4: Selection of projects based on an acceptance criterion

This is essentially a continuation of step 3 in which the organisation’s board or (if delegated) the
finance committee or finance manager will make the decision as to which projects are acceptable,
based on some predetermined acceptance criterion.

Step 5: Continuing re-evaluation of investment projects after their acceptance

Monitoring the status of a previously implemented investment project may lead to consideration of
whether the project should be continued, abandoned or modified in some respect.
 Study guide | 161

It is important to note that an inaccurate estimation of future cash flows and improper evaluation
of these cash flows is often linked not only to investment failures but, in some cases, to corporate
failures as well. In Australia there are recent examples of this, such as the surfwear retailer
Billabong International and the infrastructure group BrisConnections. Billabong’s rapid expansion
through an aggressive corporate acquisition program during the 1990s and 2000s saw its
profits peak at almost $250 million in 2007. Since then the company has seen itself come close
to collapse in 2013 when faced with weak retail conditions, excessive debt and lack of a clear
strategy in relation to its many brands. In the case of BrisConnections, the operator of Brisbane’s
$4.8 billion Airport Link toll road, excessive debt coupled with a significantly lower-than-
predicted demand led to the company going into voluntary administration in February 2013.
These cases are illustrative of problems typically faced by companies operating in an uncertain
market environment.

We focus on capital structure issues in Part B, while in this part we examine the capital
budgeting decision. Much of the focus in this part is on steps 2 to 4 in the five-step process.
Accordingly, we begin the analysis with coverage of the following four well-known investment
evaluation techniques:
• accounting rate of return (ARR);
• payback period;

MODULE 3
• net present value (NPV); and
• internal rate of return (IRR).

While these are not the only methods of investment evaluation, they are the most commonly used
in practice, and most others are essentially variations of these methods. We next illustrate how
each of these methods can be used to evaluate investment projects.

Accounting rate of return

The accounting rate of return (ARR) method involves determining the average annual accounting
profit (after depreciation) as a percentage return on the initial cash outlay. Therefore, the ARR is
calculated as the average annual profit divided by the initial cash outlay. Under the ARR method,
the decision rule is to compare the calculated ARR to a predetermined minimum ARR. If the ARR is
higher (lower) than this predetermined rate, the project would be acceptable (unacceptable).

The main advantage of the ARR is its simplicity—it is straightforward to calculate and easy to
interpret. However, this advantage is far outweighed by its disadvantages, which are as follows:

• Accounting earnings are not the same as operating cash flows. A key principle of financial
valuation is that value is embodied in operating cash flows. Accounting profits are stated
on the basis of generally accepted accounting principles (GAAP) and accounting standards,
incorporating subjective measures (e.g. accruals) and non-cash expenses (e.g. depreciation),
and are inevitably not the same as operating cash flows.

• The ARR method also ignores the time value of money, which is a critical shortcoming.
Thus, the cash flows that occur in the latter part of the project are given the same weight as
earlier occurring cash flows. This is a direct contradiction of the key finance principle that
money has time value.

• The ARR ‘cut-off’ acceptance benchmark is typically determined on a subjective basis. This is
an inappropriate basis for determining whether or not the rate of return to shareholders
is adequate.
 162 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Payback period
The payback period method involves determining the time taken for the initial outlay to be
recovered by the project’s expected net cash flows. That is, the payback period for a project is
simply the number of years it takes to recover the initial cash outlay. Using this evaluation method,
the decision rule is to compare the calculated payback period to a predetermined benchmark. If a
project’s payback period is shorter (longer) than the benchmark, the project would be acceptable
(unacceptable).

For projects with future cash flows consisting of an annuity, the payback period is easily computed
by dividing the initial investment by this cash flow annuity. More generally, calculating the
payback period requires an assumption that the future cash flows are evenly distributed over
the year. This allows us to compute the payback period in fractions of the year, as illustrated in the
following example.

Example 3.1: Computing the payback period

Compute the payback periods for Projects A, B and C with the following initial outlays and future
expected cash flows.
MODULE 3

Project A Project B Project C

Year 0 –$150 000 –$150 000 –$150 000
Year 1 $60 000 $80 000 $120 000
Year 2 $60 000 $60 000 –$50 000
Year 3 $60 000 $50 000 $100 000
Year 4 $60 000 $60 000 $100 000

Solution
For Project A, the payback period is easily computed by dividing the initial investment by this cash flow
annuity as follows:

Payback for Project A = 150 000 / 60 000 = 2.5 years

For Project B, by the end of the second year $140 000 will be earned. The last $10 000 would be
earned in the third year. Assuming that the cash flow of $50 000 is evenly distributed over the third
year, the payback period can be computed as:

Payback for Project B = 2 + 10 000 / 50 000 = 2.2 years

For Project C, by the end of the first year $120 000 will be earned, leaving $30 000 to be earned in
year 2. However, the year 2 cash flow is negative which gets added to the $30 000 still to be earned
in year 2 resulting in a total of $80 000 to be earned in year 3. Assuming that the cash flow of $100 000
is evenly distributed over the third year, the payback period can be computed as:

Payback for Project C = 2 + 80 000 / 100 000 = 2.8 years

As with the ARR method, the main advantage of the payback period method lies in its simplicity,
both in its calculation and interpretation. Also, as in the case of ARR, the problems associated
with the payback period method far outweigh these benefits. The method fails to account for
the time value of money because all cash flows up to the payback period are implicitly equally
weighted. Another critical shortcoming of the payback period method is that the method ignores
any cash flows that are expected to be realised after the payback period. In the example above,
the cash flows in year 4 are ignored for all three projects. Finally, the payback period benchmark
is typically determined subjectively and is therefore not adequate in determining the worth of the
project to shareholders.
 Study guide | 163

Net present value

The net present value (NPV) method of project evaluation uses discounting of net cash flows
to convert all future cash flows to their present values. Specifically, the NPV is calculated by
discounting all expected cash inflows and outflows of a project to their present value, using an
appropriate discount rate. The positive and negative present values are then netted off against
one another, giving the project’s NPV. Under this method, it can be determined whether or not
the future cash flows expected from an investment project justify the cost of the project. If the
NPV is positive, the project should be accepted; if negative, it should be rejected. If the NPV is
zero, the company would be indifferent between accepting or rejecting the project. The NPV
is calculated as follows:

NPV = C1 / (1 + k)1 + C2 / (1 + k)2 + … + Cn / (1 + k)n – I0 (1a)

or

n
Ct
=
NPV ∑ − I0
(1 + k )
t
t =1 (1b)

MODULE 3
where:
Ct = expected net cash flow at the end of time period t
n

∑ =

t =1
the summation operator which sums the present value of net cash flows
at the end of time period 1 through to the end of time period n
k = required rate of return on the investment
I0 = initial cash outflow
n = the project’s time horizon

In the above formula we sum all future net cash flows expected in future time periods, t,
discounted using the required rate of return on the investment, k. The discount rate, k,
is either the organisation’s overall cost of capital or a project-specific required rate of return.
We consider the issues related to measuring the cost of capital (or required rate of return),
in part B of this module.

Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that equates the present value
of a project’s cash inflows with the present value of its cash outflow(s). This is the equivalent
of saying that the IRR is the discount rate at which the NPV of the project is equal to zero.
So, we can compute the IRR using the NPV relationship, as follows:

n
Ct
NPV= 0= ∑ − I0
(1 + IRR )
t
t =1
(2)

The decision rule is to accept (reject) the project if the IRR is greater (lower) than the required rate
of return (k) on the project. An IRR greater (lower) than the required rate of return implies that the
project is a positive (negative) NPV project because the IRR is the discount rate that makes the
project’s NPV equal to zero. If the IRR is equal to the required rate of return, then the project’s
NPV is zero and the company would be indifferent between accepting or rejecting the project,
as before.

The IRR is relatively easy to compute for projects that have single cash flows as illustrated in
Example 3.2.
 164 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Example 3.2: Computing the internal rate of return

Compute the IRR for the following projects:

• A one-year project involving an initial outlay of $100 000 followed by a net cash inflow of $120 000
at the end of year 1.

• A four-year project with an initial outlay of $120 000 which has a long development period resulting
in a net cash inflow of $240 000 at the end of year 4 and no cash flows over years 1 to 3.

Solution

The IRR of the first project can be easily calculated as follows:

NPV = 0 = 120 000 / (1 + IRR) – 100 000

So, IRR = 120 000 / 100 000 – 1 = 0.2 or 20%

In the second case, the project’s IRR can also be computed relatively easily as there is only one future
cash flow:
MODULE 3

NPV = 0 = 240 000 / (1 + IRR)4 – 120 000

So, IRR = (240 000 / 120 000)1/4 – 1 = 0.1892 or 18.92%

We next turn to an example that illustrates each of the four methods of project evaluation in
more detail.

Example 3.3: Evaluating capital budgeting techniques

TCL Ltd is considering investing funds in a new machine with an initial outlay of $600 000. The machine
is expected to have an economic life of five years and generate annual net cash inflows of $200 000
per year. Assume that this amount also represents the net accounting profit before depreciation.
The machine will be depreciated over five years on a straight-line basis and its salvage value at the
end of five years is expected to be zero. Also assume that the cash flows are received at the end of
each year and that there are no taxes or transactions costs. The company uses a minimum ARR
of 14 per cent per annum and a benchmark payback period of two years to evaluate its investment
projects. The company’s cost of capital is 16 per cent per annum. Evaluate the project using the ARR,
payback period, NPV and IRR methods.

Accounting rate of return

To compute the ARR we first need to calculate the average annual profit, which requires the annual
depreciation expense. The depreciation expense, net profit and ARR are as follows:

Depreciation expense = 600 000 / 5 = $120 000 per annum

Annual net profit = 200 000 – 120 000 = $80 000 per annum

ARR = 80 000 / 600 000 = 0.1333 or 13.3 per cent per annum

Since the predetermined cut-off ARR is 14 per cent, the project would be rejected as its ARR is
13.3 per cent.

Payback period
In this example, the payback period is:

600 000 / 200 000 = 3 years

Since the company’s benchmark payback period is two years, the project would be rejected.
 Study guide | 165

Net present value

The shortcomings of the ARR and payback period methods are overcome by the IRR and NPV methods,
which are based on the principles of discounted cash flow analysis. Most importantly, these methods
explicitly incorporate both the timing and magnitude of forecast cash flows.

In our example, the NPV is:

NPV = 200 000 × [1 – (1 + k)–n] / k – 600 000

NPV = 200 000 × [1 – (1.16)–5] / 0.16 – 600 000

NPV = $54 859

Note that in the above calculation the expression [1 – (1.16)–5] / 0.16 equals the present value of a
$1 annuity discounted at an interest rate of 16 per cent over five years. If you are not already familiar
with such calculations, you should read Appendix 3.1, which contains a review of financial mathematics
required for this module.

As the NPV of the project is positive, it should be accepted. An interpretation of the NPV is that it
measures the contribution that a project makes to the value of the company. Thus, this project adds
$54 859 to the value of the company. So, accepting the project is consistent with the objective of

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maximising company value.

Internal rate of return

In our example, the IRR is obtained by using the following expression to solve it:

0 = 200 000 × [1 – (1 + IRR)–5] / IRR – 600 000.

Unfortunately, with the exception of single cash flow projects, as shown above, there is no simple method
for calculating a project’s IRR. It can, however, be calculated by using the IRR function on a financial
calculator, spreadsheet program or by trial and error involving interpolation, which is explained below.

We know that the IRR is, by definition, the discount rate at which the NPV of a project’s cash flow is
equal to zero. As zero is a number that lies between a positive number and a negative number, it follows
that the IRR must lie between a discount rate that results in a positive NPV and another that results in a
negative NPV. This is where the trial and error aspect of the calculation comes in. We need to ‘guess’ a
starting point to perform the interpolation. Assume that we first guess a rate of 20 per cent. Applying
this discount rate to the project’s cash flows results in an NPV of –$1 878, as follows:

NPV = 200 000 × [1 – (1.20)–5] / 0.20 – 600 000

NPV = –$1878

As this is a negative NPV, we know that the project’s IRR is below 20 per cent. So, now we guess a lower
rate, say 19 per cent. This rate produces an NPV of +$11 527.

NPV = 200 000 × [1 – (1.19)–5] / 0.19 – 600 000

NPV = $11 527

Now we know that the IRR lies between 19 per cent and 20 per cent. Specifically, the IRR is at least
19 per cent, plus some proportion of the difference between 19 per cent and 20 per cent (that is,
1 per cent). The interpolation calculation is as follows:

IRR = 0.19 + [11 527 / (1878 + 11 527)] × 0.01 = 0.1986 or 19.86%

Fortunately, financial calculators and spreadsheet programs can automatically calculate the unknown
IRR in a few seconds using the applicable formula and solving for the unknown IRR.
 166 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

In making the investment decision, a project’s IRR is evaluated against a predetermined hurdle rate
which is typically either the organisation’s cost of capital or a project-specific hurdle rate. In this example,
using the cost of capital of 16 per cent, the project is acceptable since the IRR is above this rate.

In Example 3.3, both the accounting rate of return and the payback period methods determined
that the project would be rejected. However, this is the incorrect decision as the NPV of this
project was positive, implying that the project added value to the company and should be
accepted. The NPV method is generally regarded as the best method of project evaluation
because it explicitly takes into account the time value of money as well as the risk of cash flows.
Although the IRR method also takes the time value of money into account, it can produce results
that contradict the NPV method, as described in the next section.

➤➤Question 3.1
KML Ltd wishes to analyse a proposed project using the NPV method. The outlay on the proposed
project is $480 000. The organisation has forecast the year-end cash flows shown in the table below.
The required rate of return is 15 per cent per annum. KML Ltd has approached you for advice.

End of year Forecasted cash flow

0 –$480 000
MODULE 3

1 $200 000
2 $250 000
3 $250 000

(a) Compute the NPV of the project. What decision should the company make regarding
this project and why?
(b) A shareholder of KML Ltd asks you what meaning can be attributed to the net present value
calculated in part (a). Provide a concise explanation.
(c) Compute the project’s IRR. What decision should the company make regarding this project
and why?
(d) If the project is depreciated on a straight-line basis, compute the project’s accounting rate
of return.
(e) Compute the project’s payback period.
(f) In the past, management has invested in projects with payback periods of two years and
accounting rates of return of 20 per cent. Based on all your analysis, determine whether the
company should accept or reject the project and explain why.

NPV and IRR methods compared

In evaluating single projects, the IRR and NPV methods will lead to the same accept/reject
decision. That is, if the NPV is positive (negative), the IRR will be above (below) the hurdle rate.
This also applies to independent projects where each project can be evaluated on a stand-alone
basis. This is so because the acceptance of one project does not preclude the acceptance of
other projects.

However, when comparing mutually exclusive (or competing) projects which require a priority
ranking of projects, the two methods can lead to conflicting accept/reject decisions. This is
so because the acceptance of one project precludes the acceptance of competing projects.
This situation is of concern as it is likely that there will be more mutually exclusive projects,
rather than independent ones, being evaluated at any time.
 Study guide | 167

To illustrate this problem, consider the following table which deals with two mutually exclusive
projects that are being evaluated using a discount rate of 10 per cent.

Table 3.1: Comparing mutually exclusive projects

End of year Project A Project B

0 –$120 000 –$120 000
1 $100 000 $10 000
2 $50 000 $60 000
3 $15 000 $120 000
NPV at 10% $23 501 $28 835
IRR 24.8% 19.8%

Project A ranks higher based on the IRR method, while Project B ranks higher based on the NPV
method. If management used the IRR method of project evaluation, Project A would be chosen,
while the NPV criterion would result in Project B being preferred. To see why the two methods
provide conflicting decisions, consider the following figure where the NPV profiles of the two
projects are graphed for discount rates ranging from 0 per cent to 40 per cent. The NPV profiles
of the projects show the NPV of the projects at different discount rates. Note that the IRRs of the

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projects are the discount rates where the NPV profiles cross the X axis, that is, where NPVs of
the projects are zero.

Figure 3.1: NPV profiles of mutually exclusive projects A and B

80 000

60 000
Project B

40 000
Net present value ($)

20 000 Project A Crossover point: 13.6%

IRRA = 24.8%
0 Discount rate (%)
4 8 12 16 20 24 28 32 36 40
–20 000 IRRB = 19.8% NPVA > NPVB

–40 000 NPVB > NPVA

–60 000

The reason the two methods provide conflicting decisions is that their NPV profiles ‘cross over’
at a discount rate of 13.6 per cent. That is, at 13.6 per cent the NPVs of the two projects are
the same. As Figure 3.1 shows, for discount rates below 13.6 per cent, the NPV of Project B
exceeds the NPV of Project A. However, for discount rates above 13.6 per cent, the opposite is
true. The figure and table also show that the IRR of Project A (24.8%) is greater than the IRR of
Project B (19.8%). So, if the projects are evaluated using a discount rate above 13.6 per cent,
the ranking of the projects using the NPV and IRR methods will be the same. However,
for discount rates below 13.6 per cent these rankings differ, as shown above. In such situations,
the NPV method is the preferred method because it ensures that management will be
maximising the value of the organisation.
 168 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

The NPV method is also preferred because it does not suffer from the two other major
deficiencies associated with the IRR method, which are:

• The implicit re-investment assumption. An outcome of the IRR calculation, which is a

measure of the ‘average’ annual return over the life of the project, is that it implicitly assumes
that the cash flows received during the life of the project are re-invested at the project’s
IRR for the remainder of the project. For example, in the case of Project A, this means that
for the IRR to be correct, the cash flows in years 1 and 2 are assumed to be reinvested at
24.8 per cent until the end of year 3. Given such a high IRR, this assumption is unlikely to hold
in practice because it is unlikely that the organisation will be able to re-invest the project’s
cash flows at that high a rate of return. So, if the actual re-investment rate applicable to these
cash flows is lower than 24.8 per cent, the IRR calculation in Table 3.1 would be misleading
and the true IRR of the project would be lower than 24.8 per cent.

• Problems relating to projects with ‘non-normal’ cash flows. If we define a project with a
‘normal’ cash flow series as a single cash outlay today, followed by a series of net cash inflows
in the future, projects with ‘non-normal’ cash flows are those where there are net negative
cash flows in the future. This can lead to IRR irregularities, such as multiple IRRs or even a
negative or non-existent IRR. The following example illustrates the case of multiple IRRs.
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Example 3.4: Project with multiple IRRs

Consider the following project with a negative future expected cash flow in year 2.

End of year Net cash flow

0 –$145 000
1 $342 000
2 –$200 000

The diagram below shows the NPV profile for this project using discount rates ranging from 0 per cent
to 30 per cent. As the figure shows, this project has IRRs of 7.2 per cent and 28.6 per cent. If the
organisation’s discount rate was 12 per cent, the project would be acceptable as it has a positive NPV.
However, the two IRRs would provide a conflicting answer. Clearly, in such cases it would be preferable
to use the NPV method instead of relying on the IRR method.

Project with multiple internal rates of return, Example (a)

1 500
Net present value ($)

1 000
IRR1 = 7.2% IRR2 = 28.6%
500
0 Discount
–500 4 8 12 16 20 24 28 rate (%)
–1 000
–1 500
–2 000
–2 500
–3 000
–3 500

Note that one might argue that if we know that a project has two IRRs and the discount rate lies
within the range of these IRRs, the project’s NPV will be positive, as was the case in Example 3.4(a).
This, however, is not necessarily the case.
 Study guide | 169

Consider the project in Example 3.4(a) and assume that its cash flows are now as follows:

End of year Net cash flow

0 $145 000
1 –$342 000
2 $200 000

Note that the magnitude of the cash flows from this project is the same as in the above example but
the signs are reversed. The diagram below shows the NPV profile for this project using discount rates
ranging from 0 per cent to 30 per cent. As the figure shows, this project also has IRRs of 7.2 per cent
and 28.6 per cent. However, if the company’s discount rate was 12 per cent, the project would now
be unacceptable as it has a negative NPV!

Project with multiple internal rates of return, Example (b)

3 500
3 000
2 500
Net present value ($)

2 000
1 500
1 000

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IRR1 = 7.2% IRR2 = 28.6%
500
0 Discount
–500 4 8 12 16 20 24 28 rate (%)
–1 000
–1 500

For the reasons illustrated in Figure 3.1 and Example 3.4, the IRR is technically inferior to the NPV
method, and the latter is the preferred method for evaluating investment projects. In addition,
as mentioned in Example 3.3, a project’s NPV can be interpreted as a direct measure of the
corporate objective of maximising organisational value, that is, the value added by a project to
the organisation’s overall value. The same interpretation cannot be associated with a project’s IRR.

➤➤Question 3.2
TLT Ltd is considering the purchase of a new machine for use in its production facility. Management
has developed three alternative proposals to help evaluate the machine’s purchase. Only one
of these proposals can be implemented. Proposals A and B both have the same cost to set
up. Future net cash flows from Proposal A commence at a high rate then decline over time,
while future cash flows from Proposal B start at a low rate then increase over time. Proposal C
involves buying two of the machines considered under proposal B. That is, Proposal C is simply
Proposal B scaled up by a factor of two. The estimated net cash flows, internal rates of return and
net present values (at discount rates of 9 and 11 per cent) for Proposals A and B are summarised
in the following table.

End of Year Proposal A Proposal B Proposal C

0 –$290 000 –$290 000 –$580 000
1 $100 000 40 000 80 000
2 90 000 50 000 100 000
3 80 000 60 000 120 000
4 70 000 70 000 140 000
5 60 000 80 000 160 000
6 50 000 90 000 180 000
7 40 000 100 000 200 000
IRR 18.2% 12.8%
NPV (at 9%) $79 549 $45 064
NPV (at 11%) $59 348 $20 359
 170 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

(a) For Proposal C, calculate the IRR and the NPV at the discount rates of 9 per cent and
11 per cent.
(b) Graph the NPV profiles for the three proposals for discount rates lying between
0 per cent and 30 per cent. Mark the crossover points for the three proposals.
(Note that this part can be analysed more easily in a spreadsheet program.)
(c) (i) If the hurdle rate were 9 per cent, which project would you recommend and why?
(ii) If the hurdle rate were 11 per cent, which project would you recommend and why?
(iii) Give possible reasons for any apparent conflict between the recommendations made
using the NPV and IRR methods.

Mutually exclusive projects with different lives

So far we have compared projects which have had the same life. A problem arises when
comparing mutually exclusive projects where the lives are not the same because the termination
of one such project creates the opportunity for a new project. This situation is best illustrated
by way of an example.
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Example 3.5: C
 omparing mutually exclusive projects with
different lives
Consider the following two mutually exclusive projects where Project A lasts for two years, while Project B
lasts for three years. If the appropriate discount rate is 10 per cent per annum, which project should
the company choose based on the NPV method?

End of year Project A Project B

0 –$300 000 –$300 000
1 $180 000 $120 000
2 $180 000 $130 000
3 — $130 000

Solution
Using a 10 per cent discount rate, we can compute the NPVs of the two projects as shown in
the following table.

NPVs of mutually exclusive projects with different lives

Project A Project B
End of year Cash flows Present value at 10% Cash flows Present value at 10%
0 –$300 000 –$300 000 –$300 000 –$300 000
1 $180 000 $163 636 $120 000 $109 091
2 $180 000 $148 760 $130 000 $107 438
3 — — $130 000 $97 671
NPV $12 396 $14 200

One might think that Project B should be preferred to Project A, as it has a higher NPV. However,
this fails to take into account that at the end of year 2, Project B continues for another year whereas
Project A does not. Clearly, Project B’s continuation precludes the implementation of another project.
Note that it is also conceptually incorrect to consider only the cash flows from years 1 and 2 from both
projects because this implicitly assumes that project B is a two-year project, which is not the case.
 Study guide | 171

One method available to adjust for projects with different lives is to assume that each project will be
repeated until both projects reach a common duration (or life). This will occur at the lowest common
multiple of the lives of the competing projects. In the case of Projects A and B in Example 3.5, this would
involve Project A being repeated twice (i.e. 3 instances) and Project B repeated once (i.e. 2 instances),
giving a common life of six years. That is, we assume that if Project A is chosen, the company will
replace the project with itself in years 2 and 4, while if Project B is chosen it will be replaced with itself
in year 3. The resulting cash flows and NPVs when applying this method appear in the table below.

Comparison of mutually exclusive projects with different lives

Project A (repeated twice) Project B (repeated once)
End of year Cash flows Present value at 10% Cash flows Present value at 10%
0 –$300 000 –$300 000 –$300 000 –$300 000
1 $180 000 $163 636 $120 000 $109 091
2 –$120 000 * –$99 174 $130 000 $107 438
3 $180 000 $135 237 –$170 000** –$127 724
4 –$120 000 * –$81 962 $120 000 $81 962
5 $180 000 $111 766 $130 000 $80 720
6 $180 000 $101 605 $130 000 $73 382
NPV $31 108 $24 869

* This cash flow is obtained as: $180 000 – $300 000 = –$120 000. The $180 000 represents the final annual cash

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inflow from the previous project. The –$300 000 represents the upfront cash outflow for the next project.
** This cash flow is obtained as: $130 000 – $300 000 = –$170 000. The $130 000 represents the final annual cash
inflow from the previous project. The –$300 000 represents the upfront cash outflow for the next project.

Note that in this example, re-evaluating the two projects by making their lives comparable results in
a reversing of the ranking previously obtained and Project A is now preferred to Project B.

The alternative to the common terminal date approach is to assume continuous replacement of each
project. This is known as the constant chain of replacement assumption and, in effect, takes infinity
as the common terminal date.

The steps involved in calculating the NPV with continuous replacement are as follows.

Step 1 Calculate the NPV of each project over its estimated life. In our example, Project A’s NPV
is $12 396 and Project B’s NPV is $14 200.

Step 2 Convert these NPVs to an equivalent annual annuity (EAA) series. An equivalent annual
annuity is a uniform series of cash flows (i.e. an annuity) which has the same present value
as the original non-uniform series of cash flows. This is done by dividing the NPVs by the
present value annuity factor, that is, [1 – (1 + r)–n] / r. Applying the present value annuity factor
formula with r = 0.10 and n = 2 (for Project A) and n = 3 (for Project B), we get:

Project A’s present value annuity factor = [1 – (1.10)–2] / 0.10 = 1.7355

Project B’s present value annuity factor = [1 – (1.10)–3] / 0.10 = 2.4869

So, the EAAs of the two projects are:

Project A’s EAA = 12 396 / 1.7355 = $7142.61

Project B’s EAA = 14 200 / 2.4869 = $5709.92

 172 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Step 3 The replacement assumption means that the EAAs computed in Step 2 will be the same for
each replacement cycle. Because the EAAs are a perpetuity, their present value is obtained
as follows:

Project A’s NPV = 7142.61 / 0.10 = $71 426

Project B’s NPV = 5709.92 / 0.10 = $57 099

Project A is preferred to Project B as before. Note that the ranking obtained using the constant chain
of replacement assumption will always be consistent with the ranking obtained using the common
terminal date method. Note also that the constant chain of replacement assumption is easier to apply
in situations where the difference in project lives will result in several repetitions of each competing
project. For example, a comparison of projects with lives of seven and nine years respectively would
require the first project to be invested in nine times and the second project to be invested in seven
times. In such a situation the constant chain of replacement assumption would be much simpler to
apply, as illustrated in the following question.

➤➤Question 3.3
Arena Ltd is evaluating two types of machine for its new manufacturing facility in Melbourne.
MODULE 3

Machine X has a life of seven years, while machine Y has a life of nine years. The initial outlay
(in year 0) and net annual operating costs associated with these machines are given in the following
table. The machines are not likely to affect the company’s revenues, so these are not considered
when comparing the two machines. The company’s required rate of return is 10 per cent per annum.

End of year(s) Machine X Machine Y

0 $400 000 $450 000
1–7 $50 000 $40 000
8–9 — $40 000

(a) Compute the net present value of each machine.

(b) Your assistant asserts that the machine which has the lowest cost (in net present value terms)
should be selected. Explain to your assistant why this reasoning is incorrect.
(c) How should the company evaluate the two machines? What decision should the company
make and why?
 Study guide | 173

Part B: C
 ost of capital and capital
structure
As discussed in Module 2, companies can obtain long-term finance by issuing either debt or
equity (i.e. ordinary shares). The variety of debt, equity and hybrid instruments available in capital
markets allows companies considerable scope in tailoring their capital structure to meet their
specific requirements. In order to contain the subsequent discussion of capital structure to a
manageable level, the examples used in this section proceed on the basis of a simplified capital
structure consisting of debt and equity, or debt, equity and preference shares.

The issues addressed in this section are as follows:

• In light of the range of funding choices available, how should a company’s financial structure
be determined?
• Is there an optimal or target debt–equity ratio that companies should attempt to achieve?
• If there is an optimal debt–equity ratio, what factors influence its choice?

We first discuss the qualitative factors and then turn our focus to the quantitative factors relevant

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to the cost of capital and capital structure decisions.

Qualitative factors
The main qualitative factors that are often considered in the capital structure decision include:
• Nature of assets. A primary consideration in determining a company’s capital structure is its
underlying asset structure. Companies whose assets are ‘in place’ and generating a relatively
predictable stream of cash flows can safely employ higher levels of debt than can companies
whose assets consist largely of growth options. For example, a property developer whose
major asset is a tract of undeveloped land should carry much less debt than a developer
whose assets include established shopping centres.
• Stability of earnings. Companies with stable earnings streams can carry more debt than
those whose earnings are subject to wide fluctuations. For example, finance companies,
whose earnings are relatively predictable, normally carry higher debt levels than
manufacturing companies which are subject to the uncertainties of the business cycle.
• Flexibility. Debt is usually more flexible than equity in that it can be repaid or redrawn
in varying amounts at any time. In general, debt can be raised more easily and at lower
transaction costs than equity.
• Control. Debt involves a straightforward contract which creates rights and obligations
for both borrower and lender. Except in the case of default, the lender has no say in the
management of the company, whereas equity carries with it the additional benefits (and risks)
of ownership.
• Risk. Because debt creates a fixed obligation, it increases the overall risk of a company.
This risk arises from two sources:
–– Repayment risk. If a company cannot repay its debt when it falls due, it is technically
insolvent. The debt may be restructured or rescheduled by agreement with the lenders;
otherwise, the company may face liquidation.
–– Interest rate risk. Inability to meet interest payments as they fall due is a common cause
of business failure. Interest commitments which are manageable during an expansion
phase of the business cycle may be unmanageable during an economic downturn or
recession. Also, this risk is a function of the proportion of fixed-rate versus floating-rate
borrowing in the organisation’s interest rate structure.
 174 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

• Cost. As mentioned in Module 2, from a company’s point of view, debt is generally cheaper
than equity. This is due to the obligation placed on the borrower to make interest payments
and repay the debt at maturity. Since equity does not involve these obligations, lenders are
normally prepared to accept a lower rate of return than that required by shareholders.
In addition, the cost of debt is normally tax deductible which further reduces the cost of debt.
• External constraints. A company’s level of debt is also subject to the constraints imposed
by outside parties, such as banks and other lenders, dominant shareholders and ratings
agencies.

We now examine the issues associated with measuring the costs of the different components of
capital structure, focusing on debt, equity and preference shares.

Quantitative factors
Cost of debt
For the purposes of illustration, we focus on a specific class of debt: fixed‑interest securities,
or bonds. Here, we use the generic term ‘bond’ to cover all fixed‑interest securities. A bond
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may be defined as a contract between the issuer (borrower) and the investor (lender) where the
issuer has the obligation to make pre‑specified cash payments to the investor on pre-specified
future dates.

As is the case with other financial assets, the valuation of bonds is based on present value
concepts. The key variables are the timing of cash flows, time to maturity and the market yield.
The cash flows associated with holding a bond are the periodic interest payments which are
determined by the coupon rate attached to the bond and repayment of the face value on
maturity of the bond. Given the coupon rate, the coupon (or interest) payment in time t can
be computed as:

Coupon payment, Ct = Coupon rate × Face value

Also, because the coupon payments are an equal periodic cash flow, they can be valued as the
present value of an annuity.

The market yield on a bond is the company’s cost of debt, denoted as kd. This can be thought
of as the rate of return currently required to induce investors to hold the bond. Therefore,
it is the discount rate that equates a series of cash inflows—the bond’s interest and face value
repayment—with the bond’s current price. An important point to note is that the only time the
market yield on a bond is the same as its coupon rate is when the bond is trading at its face
(or par) value.

In general, the market value of a bond can be computed as:

P0 = C1 / (1 + kd )1 + C2 / (1 + kd )2 + … + Cn / (1 + kd )n + Fn / (1 + kd )n (3a)

or

n
=
P0 ∑C
t =1
t / (1 + kd )t + Fn / (1 + kd )n (3b)
 Study guide | 175

where:
P0 = current market price of the debt security
n

∑
t =1
= the summation operator

Ct = cash flow for each time period t

Fn = face value of the bond
kd = required rate of return on debt (yield)
n = number of years in which the debt matures

As mentioned, because the coupon payment made by the issuer is an annuity over the life of the
bond, the above expression can be rewritten as:

=
P0 C { [1 − (1 + kd )−n ] / kd } + Fn / (1 + kd )n (3c)

= C { [1 − (1 + kd )−n ] / kd }is+ the

P0 where (1 + kd )nvalue of a dollar annuity over n time periods discounted
Fn /present
at the required rate of return on debt, kd .

Example 3.6: Price of debt

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A four-year bond with a face value of $100 000 carries a coupon of 8 per cent per annum paid annually
in arrears. What is the bond’s current price, given a market yield of 6 per cent per annum? What is the
price of the bond if the coupons are paid semi-annually rather than annually?

Solution
The annual coupon paid on the bond is 100 000 × 0.08 = $8000 and the bond matures in four years.
So, the market price of the bond today is:

P0 = 8000 {[1 − (1 + 0.06)–4 ] / 0.06}+ 100 000 / (1 + 0.06)4

P0 = 27 720.84 + 79 209.37

P0 = $106 930

As bonds typically make coupon payments on a semi-annual basis, we also compute the price assuming
semi-annual coupons. In this case, the semi-annual coupon is 100 000 × 0.08 / 2 = $4000. Since the
coupons are paid semi-annually, we need the semi-annual market yield to discount these coupons to
the present, that is, 0.06 / 2 = 3%. Also, the total number of semi-annual coupons that the company
will pay is 4 × 2 = 8.

The market price of the bond with coupons paid semi-annually is:

P0 = 4000{[1 − (1 + 0.03)–8 ] / 0.03}+ 100 000/(1 + 0.03)8

P0 = 28 078.77 + 78 940.92

P0 = $107 020

Note that in this example the bonds are selling at a premium to the face value. This follows because
the market yield is lower than the coupon rate promised by the company. That is, investors view an
annual return of 6 per cent as being adequate to compensate them for the risk level of these bonds.
As the company is promising a higher coupon rate of 8 per cent, investors would be attracted to
these bonds, resulting in the bond price rising above the face value. Conversely, if the market yield
was higher than the coupon rate promised by the company, the bonds would be selling at a discount
to their face value. For example, if the annual market yield was 10 per cent (assuming annual coupon
payments), investors would view the coupon rate of 8 per cent as being an inadequate return to
compensate them for the risk level of these bonds.
 176 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Consequently, investors would tend to sell these bonds and invest elsewhere, resulting in the price
of the bonds falling to levels below the face value. In this case, assuming annual coupon payments,
the market price would be:

P0 = 8000 {[1 − (1 + 0.10)–4] / 0.10}+ 100 000 / (1 + 0.10)4

P0 = 25 358.92 + 68 301.35

P0 = $93 660

Given the future cash flows from a bond and its market price today, we can compute the market
yield, as illustrated in the following example.

Example 3.7: Cost of debt

A one-year bond with a face value of $100 000 carries a coupon of 5 per cent per annum with coupons
paid annually in arrears. What is the bond’s yield to maturity if its current market price is $95 455?

Solution
The yield to maturity (kd ) can be computed as follows:
MODULE 3

P0 = 95 455 = (5000 + 100 000) / (1 + kd )

So, kd = (105 000 / 95 455) – 1

kd = 0.10 or 10%

Note that there is no simple, direct method of computing the yield to maturity for bonds which mature
over periods greater than one year. This calculation is essentially an internal rate of return calculation
which can be done using a financial calculator, a spreadsheet program or by trial and error and solving
for the unknown IRR. This issue was discussed in more detail in Part A in the section entitled ‘Internal
rate of return’.

Cost of equity
Unlike debt, equity does not involve contractual obligations to pay interest or principal.
Nevertheless, shareholders require a rate of return on their investments and this represents a
cost to the company.

The cost of equity may be thought of as the rate that a company must offer its shareholders in order
to maintain the current share price. If this rate is not maintained, the share price will adjust to bring
the expected return in line with the required return. This adjustment process is likely to be rapid in an
efficient market environment in which numerous other stocks are available that do provide a similar
required return.

Because dividend payments are subject to fluctuation over time, and because the actual return
received by an investor comprises both a dividend component and a capital gain component,
the measurement of the required return on equity is less straightforward than for other sources of
capital. Note also that in Australia, measuring the required return on equity is even more complex
due to the existence of the dividend imputation system and franking credits.

A theoretical model for specifying the required return on the equity component of an investment
is provided by the capital asset pricing model (CAPM). While the empirical validity of this model
has been challenged, it is probably the best-known method for measuring the required return
and is widely used by investment analysts and fund managers.

As the CAPM relies on the concepts of systematic risk and diversification, it is useful to examine
these concepts prior to describing the model.
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Risk and diversification

Risk is defined as the variability of return around an expected (or mean) value, and is measured
by the variance or standard deviation of the returns on a security or asset. Figure 3.2 illustrates
the total risks of two different equity securities. Note that both securities have the same expected
return but the security on the right-hand side is riskier because of the greater dispersion in its
returns around its expected return.

Note also that high risk results in a high standard deviation of returns, and vice versa. This concept
of risk is somewhat different from the popular understanding of risk which equates risk with the
chance of a loss, or with outcomes below what are expected. This risk of loss is often called
‘downside risk’. In that sense, the standard deviation measures both downside risk as well as
upside potential.

Figure 3.2: Total risks of two different equity securities

Lower-risk asset Higher-risk asset

Probability

Probability

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Rate of return Rate of return

There are two components to total risk, a distinction that is important for the CAPM. These are:
• Systematic risk, which represents the part of a security’s return that is due to movements in
the share market as a whole and that cannot be diversified away by adding more and more
securities in a portfolio. Systematic risk is also known as market risk or non-diversifiable risk.
For example, unexpected movements in interest rates constitute a systematic risk for many
companies, and banks in particular.
• Unsystematic risk, which represents that part of a security’s return that is due to the unique
characteristics of that security which can be eliminated through diversification. Unsystematic risk
is also known as unique risk or diversifiable risk. For example, the resignation of a company’s
CEO or a lawsuit filed against a company constitutes a risk specific to that company, which can
be diversified away by investing in different securities or across different asset classes.

Under portfolio theory, it is assumed that investors hold large, well-diversified portfolios of
securities and that this diversification can be achieved without cost. Stated differently, investors
are able to eliminate unsystematic risk via portfolio diversification. Accordingly, systematic risk
is the only risk which is relevant to the pricing of securities since investors cannot expect to be
rewarded for bearing risk that can be eliminated via portfolio diversification.
 178 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Capital asset pricing model

The CAPM specifies the relationship between a security’s systematic risk and its required return.
The CAPM makes the following main assumptions about investor behaviour:
• investors are risk averse, which means that they require additional return for assuming
additional systematic risk;
• investors hold well-diversified portfolios whereby unsystematic (or security-specific) risk is
eliminated; and
• investors have homogeneous beliefs about the risk and expected return attributes of all
publicly traded securities.

According to the CAPM, the minimum total return that a company offers its investors—its cost of
equity—must be equal to the risk-free rate of return plus a premium to compensate investors for
bearing the systematic risk associated with the company’s shares. That is:

Required return on investment = Risk-free return + Risk premium

The risk premium comprises two components: the market price of the systematic risk and the
quantity of systematic risk borne by investors. That is:
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Risk premium = Market price of risk × Amount of risk

In other words, the CAPM states that the required excess return (that is, the required return
above the risk-free rate) on any risky security is directly proportional to its systematic risk.
The higher the systematic risk, the higher the expected excess returns, and vice versa. As the
CAPM assumes that investors hold the market portfolio, the market price of risk is the excess
expected return that investors expect to earn on the market portfolio, or E(rm) – rf . This premium
is also referred to as the market risk premium. The amount of risk is measured as the stock’s
systematic risk, ße. So, the CAPM can be written as:

rf [E (rm ) − rf ]βe
ke =+ (4)

where:
rf = the risk-free interest rate
E(rm) = expected return on market portfolio
E(rm) – rf = the expected market risk premium
ße = the systematic risk of a security

The systematic risk of the company’s shares is measured by its beta. Accordingly, the company’s
beta measures the risk associated with its shares relative to the market portfolio. Since the market
portfolio is assumed to comprise all risky assets, its beta is 1.0. This means that a company with
a beta that is less (greater) than 1.0 has less (more) systematic risk than the market portfolio.
For example, if the market return increased by 1 per cent on a particular day, the return on a
stock with a beta of 1.5 would be expected to increase by 1 × 1.5 = 1.5 per cent, while the return
on a stock with a beta of 0.7 would be expected to rise by only 1 × 0.7 = 0.7 per cent. Thus,
stocks with a beta greater than 1.0 are riskier relative to the market portfolio, while stocks with a
beta lower than 1.0 are less risky relative to the market portfolio.

The relationship between systematic risk and expected return implied by the CAPM is illustrated
in Figure 3.3.
 Study guide | 179

Figure 3.3: Required return and systematic (beta) risk

E(ri )

M
E(rm )

rf

β
0 1.0

The line rf MZ is called the security market line (SML). In equilibrium, all securities must plot on
this line. Any security with an expected return lying below the SML would be overpriced because
its expected return is lower than its equilibrium return. Investors would prefer to invest in other

MODULE 3
similar risk securities which offer a higher expected return for the same level of (systematic) risk.
The overpriced security’s demand would fall and its price would fall until its expected return
rises to be equal to the equilibrium return. The opposite scenario would apply to securities lying
above the SML. This is illustrated in Example 3.8.

Example 3.8: Using the Security Market Line

An investor is considering investing in JCT Ltd’s stock with a beta of 0.9. The risk-free rate is 7 per cent
and the expected market risk premium is 8 per cent. What is the required return on this stock and
what is the company’s cost of equity? Suppose the stock was priced so that its expected return was
(a) 12 per cent or (b) 16 per cent. What would happen to the stock’s price in equilibrium in each case?
Explain your reasoning.

Solution
Using the CAPM, we have:
ke = 0.07 + (0.08 × 0.9)
ke = 0.142 or 14.2%

Thus investors require a return of 14.2 per cent on this stock.

Note that from the point of view of the company, the 14.2 per cent required return can be interpreted
as the company’s cost of equity. This is so because the return required by investors of 14.2 per cent is
a cost to the company of raising funds using equity.

If the stock was priced to earn investors an expected return of 12 per cent, the demand for this stock
would fall and its price would be bid down until, in equilibrium, its expected return rose to the required
return of 14.2 per cent. That is, when the stock’s expected return lies on the SML. On the other hand, if the
stock was priced to earn investors an expected return of 16 per cent, the demand for this stock would
rise and its price would be bid up until its expected return fell to the required return of 14.2 per cent.
 180 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

CAPM: Practical issues

Although the foregoing discussion indicates that it is fairly straightforward to apply the CAPM to
determine a cost of equity, there are some practical issues that can complicate the calculation.
Look again at the CAPM equation:

rf [E (rm ) − rf ]βe
ke =+ (4)

To use the CAPM to estimate the company’s cost of equity, we need information on the following:
• rf  , the current risk-free interest rate;
• E(rm) – rf  , the expected market risk premium; and
• ße , the company’s beta.

Probably the least problematic of the three is the risk-free interest rate in the market. While there
is probably no truly risk-free security in existence, the practical solution is to use low–default-risk
government bonds or treasury notes as a proxy for the risk‑free rate of return. The maturity of
the risk-free security should be matched, as closely as possible, to the maturity of the investment
project for which the cost of equity is being estimated. Accordingly, a six-month project would
imply using the 180-day Treasury Note rate, while a longer-term Treasury Bond rate would be
appropriate for a long‑term project.
MODULE 3

To estimate the market risk premium, we need the expected return on the market portfolio,
E(rm). In theory, the market portfolio contains all possible risky securities traded in the market.
In practice, of course, it is impossible to observe this market portfolio. However, in most
markets, E(rm) is measured as the return on a broad index of securities traded on that market.
In Australia, the indices most commonly used are the S&P/ASX 200 Index and, to a lesser extent,
the All Ordinaries Index.

A favoured alternative to estimating E(rm) is to apply historical knowledge of the market risk
premium, rm – rf . A number of studies of rates of return have indicated that this premium has
historically been in the order of 6 to 8 per cent. So, rather than attempting to estimate E(rm),
this method directly inputs the market risk premium into the CAPM. It should be noted, however,
that these studies pre-date the effects of the dividend imputation taxation system in Australia,
and it has been argued that the effect of this system has been to reduce the market risk premium.

Estimating a company’s beta, which measures the risk associated with the company’s shares
relative to the market portfolio, is perhaps the most difficult. Typically, this involves estimating
a simple linear regression of historical returns on the company’s stock against those on the
overall market portfolio. The slope of the regression line gives us the estimate for the company’s
beta. Alternatively, the beta can be purchased from commercial organisations that specialise in
estimating betas.

Note that in estimating the above parameters, we are using historical returns and betas to
estimate the cost of equity. This implies that past performance is expected to repeat in the
future, which we know is often not the case. This is one of the perennial problems in financial
estimation and forecasting, but is typically justified on the basis that there are no demonstrably
superior alternatives to using historical data.

In two influential studies in 1992 and 1993 respectively, Fama and French evaluated the joint role
of the market portfolio, company size, the earnings-to-price ratio, company leverage and the
book-to-market value of equity ratio in explaining the cross-section of average returns on shares
traded on the NYSE, AMEX, and NASDAQ markets. They found that, in addition to the market
portfolio ‘factor’, portfolios based on company size and the book-to-market ratio also explained
the behaviour of realised returns over their sample period. Based on the size and book-to-market
factors Fama and French proposed the following three-factor asset pricing model:

( )
E rj =rf + β jm E (rm ) − rf  + β jS E ( SMB ) +β jHE (HML ) (5)
 Study guide | 181

In this model, the expected return on company j is equal to the risk-free return plus three specific
factors. The first factor is the market factor from the CAPM (already discussed). The second factor
is based on the returns on diversified portfolios of small market capitalisation shares minus big
market capitalisation shares (i.e. ‘small minus big’, or SMB). It has been observed that companies
with small market capitalisation tend to behave very differently when compared with companies
with large market capitalisation in most market conditions. In the long run, small‑sized companies
have generated higher returns than large-sized companies because of the higher perceived risk
levels associated with them. Fama and French (1992, 1993) used company size as a separate
factor that influences the returns on individual shares and portfolios. The third factor is the returns
on diversified portfolios of high book-to-market shares minus low book-to-market shares (that is,
‘high minus low’, or HML). High (low) book‑to-market stocks tend to be ‘value’ (‘growth’) shares.
Fama and French (1992, 1993) found that the book-to-market ratio was positively related to
realised returns with high (low) book-to-market stocks exhibiting high (low) future realised returns.
This relationship is economically significant and persists after controlling for company size and
beta (or market) risk.

As in the case of the CAPM, the betas associated with each factor capture the sensitivity of
expected returns to those factors. The following example compares the CAPM with the three-
factor model.

MODULE 3
Example 3.9: Comparing the CAPM and the three-factor model
An investor is considering investing in TCJ Ltd’s stock with a CAPM beta of 1.5. The risk-free rate is
7 per cent and the expected market risk premium is 8 per cent. Using the CAPM, what is the required
return on this stock? Next, assume that the Fama and French three-factor model describes the behaviour
of security returns. Assume that the company’s sensitivity to the market factor remains unchanged and
that the SMB and HML factor returns are expected to be 5 per cent and 7 per cent respectively. Also,
TCJ’s sensitivity to these two factors has been estimated as being –1.2 and 1.2 respectively. Using the
three-factor model, what is the required return on this stock? What are the implications of the above
analysis for the company’s cost of capital?

Solution
Using the CAPM, we have:
ke = 0.07 + 0.08 × 1.5
ke = 0.19 or 19.0%

Using the three-factor model, we have:

ke = 0.07 + 0.08 × 1.5 + 0.05 × –1.2 + 0.07 × 1.2
ke = 0.214 or 21.4%

A sensitivity of –1.2 and 1.2 to the SMB and HML factors implies that if the returns on these factors
unexpectedly rise (fall) by 1 per cent then the company’s return will fall (rise) by around 1.2 per cent.
That is, the company’s returns are negatively sensitive to the SMB factor and positively sensitive to
the HML factor. The above analysis implies that the cost of capital that the company should use
differs depending on which model is used to estimate it. While the CAPM implies a cost of capital of
19 per cent, the three-factor model implies a cost of capital of 21.4 per cent. If company management
believes that the three-factor model is a better depiction of how security returns are determined then
a cost of capital of 21.4 per cent would be the appropriate metric to use.

It is important to note that the Fama and French three-factor model originated from an analysis
of empirical data and not economic theory, unlike the CAPM. While the three‑factor model does
a good job in describing the behaviour of returns over the sample periods examined by Fama
and French, caution should be exercised as there is no reason to believe that the model will
perform just as well in the future.
 182 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Cost of preference shares

Preference shares are known as a hybrid security because they have some of the features of
debt and some of the features of equity. The debt-like features include the fact that preference
shares pay a fixed dividend (similar to the coupon on a bond), are typically non-voting and have
priority over ordinary equity for both dividends and capital return. On the other hand, the equity-
like features are that they are legally shares, pay a dividend and not interest, and typically do
not have a maturity date. They also rank behind debt in relation to entitlements to income and
capital returns.

If a preference share is non-redeemable, that is, it does not have a maturity date, as is the case
with most preference shares, it can be valued as a simple perpetuity, as follows:

P = Dp / kp (6)

where:
P = the current price of preference shares
Dp = value of annual dividend on preference shares
kp = the current market cost of preference shares
MODULE 3

Example 3.10: Cost of preference shares

HHC Ltd has 10 per cent $5 preference shares on issue, which are currently trading on the market
at $7.50 each. What is the current market cost of these preference shares?

Solution
kp = Dp / P = $0.50/$7.50 = 0.0667 or 6.67%

Weighted average cost of capital

We are now in a position to estimate the company’s overall cost of capital, which is a weighted
average of the individual costs of the various financing instruments used by the company to fund
its investment opportunities. This weighted average cost of capital (WACC) depends on the
following factors:
• the cost (in percentage terms) of each financing instrument; and
• the proportion (or weight) of each financing instrument.

WACC (k0) is defined as:

k0 = kd(D / V ) + kp(P / V ) + ke(E / V ) (7)

where:
D = market value of the company’s debt
E = market value of the company’s equity
P = market value of the company’s preference shares
V = total market value of the company (= D + P + E)
ke = cost of equity capital
kd = cost of debt capital
kp = cost of preference shares
 Study guide | 183

The calculation of WACC can be broken down into three main steps.

Step 1: Identify the financing sources used

This step involves consulting the books of account to determine the different items of capital
structure on issue by the company. Here, we may find bonds, preference shares, convertible
notes, ordinary shares and so on.

Step 2: Determine the market values of these components

Note that we use only market values of each financing instrument and not book (or historical)
values.

Step 3: Determine the annual (market) percentage cost of each financing component
Steps 2 and 3 involve extracting relevant market value information from capital markets and/or
pricing models. Note that a good rule of thumb (and a check of your calculations) is that ke > kp
> kd . This is because the risk associated with debt is the lowest since the company has to meet
its debt obligations before any dividends can be paid out to preference or ordinary shareholders.
Similarly, the risk associated with preference shares is lower than the risk associated with ordinary
shares because dividends to preference shareholders need to be paid out before any dividends
can be paid out to ordinary shareholders.

MODULE 3
The calculation of a company’s WACC is illustrated in Example 3.11.

Example 3.11: WACC

You are given the following information for ABC Ltd. Note that book values are obtained from the
company’s statement of financial position while market values are based on market data.

Book values Market values Market costs

Bonds $35 000 000 $30 000 000 5.65%
Preference shares $15 000 000 $10 000 000 8.00%
Ordinary shares $50 000 000 $75 000 000 12.00%
Total $100 000 000 $115 000 000

The cost of each capital component has been estimated as follows: kd = 5.65%; kp = 8%; ke = 12%.

Estimate the company’s WACC. The company is considering two independent projects with internal
rates of return of 12 per cent (Project A) and 8 per cent (Project B) respectively. Evaluate these projects
using the company’s WACC.

Solution
We note that ABC Ltd has debt, equity (ordinary shares) and preference shares in its capital structure.
Since the statement of financial position only gives book values, we need to determine market values
from other available data. In this example, the market values are already given. In practice, to find the
market value of a particular security, we would multiply the number on issue by the observed market
price. For example, the market value of equity equals the number of ordinary shares multiplied by the
market price per share.

Once the market value of each of the capital components is determined, the next step is to determine
the market percentage cost of each component. Points to be aware of include the following:
• In determining kd , the market yield is appropriate, not the coupon rate. Accordingly, kd is to be
calculated from the market price of debt, in a manner similar to determining the IRR of a project
(see examples above).
• In determining ke , the risk of the company and/or the project must be taken into account.
As shown above, the CAPM is the most commonly used method for estimating ke.
 184 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Since the cost of each capital component has already been estimated, we can compute WACC for
ABC Ltd as follows.

Market value Weights Costs Weights × Costs

Bonds $30 000 000 0.261 5.65% 1.47%
Preference shares $10 000 000 0.087 8.00% 0.70%
Ordinary shares $75 000 000 0.652 12.00% 7.83%
Total $115 000 000 1.000 10.00%

Note that the weights are computed by dividing the market value of each financing instrument
by the total market value of $115 000 000. These weights are computed as follows:

Bonds 30 000 000 / 115 000 000 = 0.261

Preference shares 10 000 000 / 115 000 000 = 0.087
Ordinary shares 75 000 000 / 115 000 000 = 0.652

WACC of 10 per cent implies that the investors in this company require a minimum return of 10 per cent
from its investment projects. So, the company would prefer to invest only in Project A which has an
IRR greater than WACC.

It is important to note that WACC can only be used to evaluate investment projects that meet the
MODULE 3

following two conditions:

• The investment projects being evaluated are projects in the usual line of business of the company
(i.e. they are of ‘average’ risk). Stated differently, this means that the projects being evaluated do
not alter the business risk of the company.
• The capital structure of the company will remain similar to that at which WACC was calculated.
This implies that the company is operating under a target capital structure (or debt–equity ratio)
which it wishes to maintain for the foreseeable future. Any departures from this target ratio are
therefore considered short-term and temporary. That is, the projects being evaluated do not alter
the financial risk of the company.

In summary, the cost of capital of a company as discussed and calculated above is appropriate for
use in the capital budgeting process when evaluating projects that have the same operating risk as
the company’s typical investments, and are financed using the company’s target capital structure.

At this point it is appropriate to mention the relationship between WACC and a company’s
total market value, that is, the market value of its assets. To do this we need to assume that
the company’s operating income is independent of its capital structure. That is, the company’s
operating income is constant and is not affected by how much debt versus equity the company
uses in its capital structure. In this case, the management objective of maximising the company’s
overall market value is consistent with the objective of minimising the company’s WACC.

The economic intuition behind this conclusion is that as the company moves from financing its
operations using 100 per cent equity to a mixture of debt and equity, its cost of equity would rise.
As the company has an obligation to pay interest and repay principal on any debt borrowed, such
payments put at risk dividends and the principal amount that is invested, which are subordinate to
the debt. The equity investor therefore has greater risk as more debt is added.

While the cost of equity increases with the addition of debt, the overall WACC would tend to
decline because the company is substituting lower cost debt to finance its operations. However,
as the company takes on more and more debt to finance its operations, the cost of debt would
ultimately tend to rise along with the cost of equity. By increasing the level of debt, the company
is in a riskier position—with greater principal and interest payment obligations—resulting in higher
interest rates on debt and therefore a higher WACC.
 Study guide | 185

Thus, there will be a level of debt versus equity (D / E* in Figure 3.4) where the company minimises
its WACC. This corresponds to the point at which it maximises its market value. This optimal WACC
is illustrated in Figure 3.4 (indicated as WACC*).

Figure 3.4: Minimisation of WACC

Cost of equity ke
Cost of capital

WACC
Minimum WACC

WACC* Cost of debt kd

D/E* Debt-to-equity ratio

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It is important to note that the above analysis is a simplification of reality in the sense that, at any
given time, several factors—both quantitative and qualitative—influence a company’s capital
structure choices. It is also common for directors to set an additional capital buffer, intentionally
deciding to have excess equity rather than the optimum level, so as to protect against unexpected
losses. The extent of the buffer will depend on the board’s risk appetite. The main qualitative
factors that companies take into account were summarised at the beginning of this section.

To illustrate, in April 2013 Apple Inc. announced the largest bond issue to date by issuing USD
3 billion of floating-rate notes and USD 14 billion of fixed-rate securities, with maturities ranging
from three to 30 years. The funds raised were to be used to buy back shares of the company,
consistent with the view of management that the company’s shares were currently underpriced.
At the same time, Apple has almost USD 150 billion in cash, mostly in its overseas subsidiaries.
According to market commentators, Apple’s decision to issue these bonds was driven primarily
by: (a) its ability to issue debt at historically low interest rates and (b) its desire to avoid the
significant tax consequences associated with repatriating this cash to finance any share buyback
program. Thus, by issuing these bonds, Apple will be able to service its debt obligations using
this available cash, avoid paying significantly higher company taxes, and lower its cost of debt.

WACC with taxes

So far we have assumed no taxes. In reality, there are tax implications for organisations and it is
logical that investors will focus on after-tax returns. The question is whether companies should
focus on returns after company tax or after personal tax? The answer is that the focus should be
on after-company-tax returns. The role of management is to maximise the value of the company.

Accordingly, when we relax the ‘no taxes’ assumption, an adjustment is required to WACC to
reflect the effect of company tax. This is done to maintain consistency with the measurement
of cash flows, which can be stated on either a before-tax or after-tax basis. The nature of the
adjustment required is dependent on the taxation system in operation, that is, the classical or
the dividend imputation system. However, we first consider the before-tax WACC.
 186 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Before-tax WACC
The cost of debt, kd  , is a before-tax measure and so no adjustments are required. However,
the cost of equity, ke  , and the cost of preference shares, kp  , are already considered after-tax
measures. We can calculate the before-tax cost of equity, k ^e  , and cost of preference shares, k ^p  ,
     

as follows:

k ^e = ke / (1 – τ ) (8)

k ^p = kp / (1 – τ ) (9)

where τ is the company tax rate.

Hence the before-tax WACC is:

k ^0 = kd (D / V ) + [kp(1 – τ ) (P / V )] + [ke / (1 – τ ) (E / V )] (10)

After-tax WACC under the classical tax system

Under the classical taxation system, a company pays taxes on profits which are then distributed
MODULE 3

to shareholders in the form of dividends, and which are further subjected to tax at the individual
shareholder’s marginal tax rate.

Under this system, interest on debt is tax deductible to a company, while paying dividends has no
tax effect on the company. Accordingly, there is asymmetric tax treatment of the components of
capital structure, which requires an adjustment to WACC. With company taxes, the effective cost
of debt to the company, k*d  , is as follows:

k*d = kd (1 – τ ) (11)

Hence the after-tax WACC is:

k*0 = [kd (1 – τ )](D / V ) + kp(P / V ) + ke(E / V ) (12)

This WACC relationship effectively offsets the implicit understatement of after-tax cash flows by
adjusting k0 to reflect the tax deductibility of interest payments on debt. Thus, while kd is the cost
of debt to the company before taxes, the tax deductibility of interest payments on debt results
in the effective cost of debt being only kd(1 – τ ). Note that, in this case, the tax deductibility
of interest is taken into account in the discount rate because it lowers WACC. As a result,
we exclude both the interest and the associated interest tax shield from the cash flow calculations
because that would result in double counting the tax benefits of debt both in the discount rate
as well as in the cash flows.

To summarise, as interest on debt is typically tax deductible to the organisation, to compute the
after-tax cost of debt we multiply the before-tax cost of debt by (1 – τ ), where τ is the applicable
tax rate.
 Study guide | 187

After-tax WACC under the imputation tax system

Under the imputation tax system (which applies in Australia), a shareholder receives a franking
credit for the tax that has been paid by a company on its profits, which offsets the tax payable at
the individual’s marginal tax rate. This effectively removes the double taxation described under
the classical system.

The dividend imputation system has implications for how both WACC and cash flows are defined
and measured. Unfortunately, this results in complications to the calculation of WACC, as,
under this system, the company tax collected is a mixture of both company tax and personal tax.
While the tax collected at the company level remains the same as under the classical system,
some or all of it can be credited against personal tax at the individual level.

While the details are beyond the scope of this module, the overall effect of the imputation
system on the company’s cost of capital and capital budgeting procedures is that it requires
adjustments to both cash flows and WACC. Effectively, the after-company-tax cash flows require
the value of the imputation tax credit to be added back. One implication of all of this is that
the benefit of tax deductibility of debt is reduced because debt under an imputation tax is less
effective as a tax shield.

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Example 3.12: Classical versus imputation systems
Assume that company taxes are 30 per cent, the company distributes all after-tax profits and the
shareholders’ marginal tax rate is 40 per cent.

Classical tax system

For every $100 of profit, company tax is $30, so the dividend to shareholders is $70 (i.e. $100 – $30).
The shareholders are then taxed at their marginal rate of 40% (i.e. $28) and so the net amount received
is only $42 (i.e. $70 – $28). The shareholders have effectively paid $58 in tax (i.e. $30 + $28).

Imputation tax system

The shareholders would still receive a dividend of $70, but would also receive a $30 franking credit
(reflecting the tax already paid by the company). The shareholders declare income of $100 and the
shareholders’ tax payable at marginal rates would be $40 (i.e. $100 × 40%). However, $30 of this $40
in tax has already been paid by the company (reflected in the $30 franking credit), so the net tax
amount payable by the shareholders is only $10 (i.e. $30 – $40). The net amount received is therefore
$60 (i.e. $100 – $30 – $10), with a total of $40 tax paid.

Value of imputation credit

In this example, the shareholders’ income tax rate was higher (40%) than the company tax rate (30%),
so the shareholders would need to pay an additional $10 in tax. If the shareholders’ income tax rate
was equal to the company tax rate (i.e. 30%), there would be no tax payable. If the shareholders’
income tax rate was lower (e.g. 20%), the investor would have a leftover imputation credit worth $10
(i.e. $100 × 20%, less $30 imputation credit).

As shareholders are on different tax rates, and as some shareholders are not even entitled to the
imputation tax credit (e.g. non-Australian residents), the ‘value’ of the imputation tax credit is different
for each shareholder.
 188 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

➤➤Question 3.4
Bland Ltd is planning to undertake an investment project and needs to estimate its WACC.
The following information has been extracted from the company’s statement of financial position:

Current assets $50 000 000 Accounts payable $10 000 000
Fixed assets $100 000 000 Bonds $60 000 000
Preference shares
(5 000 000 shares issued) $50 000 000
Ordinary shares
(20 000 000 shares issued) $20 000 000
Retained earnings $10 000 000
Total $150 000 000 $150 000 000

In addition, the following information has been gathered:

• Bland’s bonds were sold five years ago at a face value of $1000 and have a coupon rate of
10 per cent paid annually. They mature in five years’ time and the current yield on similar
bonds with a five-year maturity is 12 per cent.
• The market price of Bland’s preference shares is $4.00 and the company pays dividends at
the rate of 6 per cent per annum.
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• The market price of Bland’s ordinary shares is $5.00. Its equity beta has been estimated at
1.2. The expected market risk premium is 10 per cent and government securities currently
yield 6 per cent per annum.
• The company’s tax rate is 30 per cent.

Based on the given information, compute Bland’s after-tax WACC.

 Study guide | 189

Part C: A
 dditional issues in capital
budgeting
We next consider some additional issues related to capital budgeting and capital structure.
The specific issues we focus on are:
• estimating a project’s net cash flows;
• conducting capital budgeting in an inflationary environment; and
• using the adjusted present value approach to capital budgeting.

Estimating cash flows

In estimating the expected cash flows associated with an investment proposal, it is important to
recognise that only incremental cash flows should be taken into account. These are the cash flows
that change as a direct result of the decision to undertake the project. Examples of incremental
cash flows include:

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• Working capital. Additional inventory, debtors and cash required to support a project should
be included. Normally, these amounts are recovered at the termination of the project, and
are not subject to depreciation.
• Opportunity costs. These refer to the costs associated with existing assets that the
organisation may already own and that are used in a project. For example, an organisation
may already own land on which a manufacturing facility is to be built. The alternative use
to which this land can be put must be included as an opportunity cost associated with the
manufacturing facility.
• Side effects. Adding a new product may divert sales from the organisation’s existing
products. In such a case, not all revenues from the new project are incremental. In this case,
the incremental revenue is equal to the total revenue generated by the new project less any
associated reduction in revenues from existing projects.
• Overhead cost allocations. A project should only carry overheads which are truly
incremental. Allocations of overhead costs which would be incurred whether the project
was undertaken or not should not be included in the project’s analysis.
• Tax shields. An important component of a project’s cash flow is the tax shields it generates.
Any expense which is deductible for tax purposes has a tax effect because it reduces the tax
payable. This includes depreciation which, while not an operating cash flow itself, has a cash
flow impact because of its associated depreciation tax shield. That is, only the depreciation
tax shield is included in the incremental cash flows from a project. It should be noted that tax
shields are only available to tax paying organisations.

Note that costs incurred in the past (e.g. R&D expenditures) are sunk costs, and as they cannot
be recovered they should have no bearing on whether to accept or reject a proposed project.
The fact that an organisation has incurred costs in the past does not justify further expenditures—
these are only warranted if future cash flows exceed costs in present value terms.

Interest tax shields are not included in the project’s cash flow on the grounds that they are not
project cash flows per se, but are a consequence of the particular financing used to fund the
project. Thus, the interest tax shield is incorporated into the calculation of the cost of funds
(i.e. WACC).

Example 3.13 illustrates the main ideas underlying the estimation of incremental cash flows.
 190 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Example 3.13: Estimating incremental cash flows

Consider the following pro forma statement of profit and loss and other comprehensive income
related to an investment project.

Revenues (cash) $200 000

Variable costs $60 000
Fixed costs $40 000
Depreciation $20 000
$120 000
Operating income $80 000
Less: Interest $20 000
Net profit before tax $60 000
Less: Taxes (at 30%) $18 000
Net income after tax $42 000
Dividend $18 000
Transfer to retained earnings $24 000

Which of the items in this statement of profit and loss and other comprehensive income are cash flows
that should be included when analysing this project?
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Solution
The items which represent a movement of cash are revenues, variable costs, fixed costs, interest, tax and
dividends. Depreciation is the only non-cash flow item. However, not all of these cash flows are project
cash flows. For example, interest and dividends are financing cash flows, as they are a function of
the particular financing arrangement used to fund the project. They should not be included as part of
the project’s cash flows. However, financing flows, and any associated tax shields (as discussed above),
do affect the WACC used to evaluate the project.

In this example, the calculation of the project cash flow would be as follows:

Revenues (cash) $200 000

Variable costs $60 000
Fixed costs $40 000
Depreciation $20 000
$120 000
Operating income $80 000
Less: Taxes (at 30%) $24 000
Net income after tax $56 000
Add back: Depreciation $20 000
Net cash flow $76 000

A simple equation which gives this result directly is:

Net cash flow = (Project’s incremental revenues – Project’s incremental costs – Depreciation)(1 – Tax rate)
+ Depreciation

In this example:

Net cash flow = (200 000 – 100 000 – 20 000) × (1 – 0.30) + 20 000
Net cash flow = 56 000 + 20 000
Net cash flow = $76 000
 Study guide | 191

The net cash flow equation is sometimes rewritten to identify the operating income after tax and the
depreciation tax shield, as follows:

Net cash flow = (Project’s incremental revenues – Project’s incremental costs) (1 – Tax rate) +
(Depreciation × Tax rate)

The first term in this equation is the project’s operating income after tax, while the second is
the depreciation tax shield.

Using the rewritten equation, we get the same answer as before:

Net cash flow = (200 000 – 100 000) (1 – 0.30) + (20 000 × 0.30)
Net cash flow = 70 000 + 6 000
Net cash flow = $76 000

Inflation and capital budgeting

Inflation, defined as the change in the purchasing power of money, affects the analysis of
investment projects in two ways:

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• impact on the cost of funds; and
• effect on cash flows associated with a loan or investment.

Impact of inflation on the cost of funds

Assume an individual lends $100 for one period at 4 per cent interest with an expected inflation
rate of zero. In a year’s time, the lender will receive an interest payment of $4 and the principal
of $100. The same lender, with an expected inflation rate of 5 per cent, will require a payment of
interest and principal in one year’s time of:

104 × 1.05 = $109.20

The additional $5.20 is compensation for the loss of purchasing power on the original amount
over the period of the loan. Hence, the lender’s nominal interest rate is:
109.20
r = −1
100.00
r = 0.092 or 9.2%

The real interest rate is the rate which, in the absence of inflation, equates the supply of funds
from those willing to lend for a period with the demand from those wishing to borrow for the
same period. As the above example shows, the nominal interest rate is equal to the real rate plus
a premium for expected inflation.

This relationship is the well-known Fisher equation and can be expressed as:

(1 + r) = (1 + a) (1 + ρ)(13)

where:
r = the nominal interest rate
a = the real interest rate
ρ = the expected rate of inflation
 192 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

For example, suppose the inflation rate next year is expected to be 7 per cent and investors
require a nominal rate of return of 11 per cent. The real return implied by this information is:
1+ r
1+a =
1+ ρ
1 + 0.11
a = –1
1 + 0.07
a = 0.03738 or 3.74%

As an approximation, the real interest rate can be obtained as the difference between the
nominal rate and the inflation rate:

a ≈ r–ρ (14)

In the above example, the approximate real interest rate is 11 – 7 = 4%. Note that the
approximation ignores the effect of the cross product term a × ρ which, in this example,
is 0.03738 × 0.07 = 0.00262 or about a quarter of one per cent. In cases where the real rate
and the inflation rate are relatively low, the cross product term will be small and, so, can be
ignored. On the other hand, where the real rate or the inflation rate is relatively high, the cross
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product term can be quite large and should not be ignored.

Impact of inflation on cash flows

When cash flows are estimated in current year prices, or are fixed in current year costs or prices,
they are real cash flows. When cash flows are not fixed in current year costs or prices, but will vary
according to future prices (or when their value will depend on future prices), they are nominal
cash flows.

The basic requirement in dealing with investments which are made in an inflationary environment
is to be consistent. That is, we discount real cash flows at a real discount rate and discount
nominal cash flows at the nominal discount rate. Since observed prices (or values) can be given
in both nominal and real terms, it should not matter which approach is adopted, provided that
the effects of inflation are handled consistently.

Inflation affects the analysis of investment projects in the following ways:

• Depreciation allowances for tax are based on historic rather than replacement costs.
This means that the depreciation tax shield is fixed in nominal terms. As income grows with
inflation, an increasing proportion is taxed, with the result that real cash flows do not keep up
with inflation.
• The anticipated inflation rate will be reflected in the required rate of return or cost of capital
applicable to the project. Thus, unless cash flow estimates include an anticipated inflation
allowance, a bias will be introduced into the analysis.

It is worth noting that if the distortion caused by inadequate depreciation tax shields did not
exist, anticipated inflation could be dealt with by either:
• excluding the inflation allowance from both the cash flow estimates and the discount rate
(i.e. by using a real discount rate and real cash flows); or
• specifically including an inflation allowance in both the cash flows and the discount rate.

To illustrate the bias that results if inflation is not consistently treated in both cash flows and
the discount rate, consider the project cash flows shown in Table 3.2, where the project’s cost is
depreciated on a straight-line basis over five years. Assume that cash flows have been estimated
in real terms and that the required nominal discount rate is 12 per cent and the tax rate is
30 per cent. Note that the after-tax cash flow is the sum of the operating cash flow after tax
and the depreciation tax shield.
 Study guide | 193

Table 3.2: Accounting for the effects of inflation on cash flows—Incorrect procedure

Real Real
before-tax after-tax
Project operating operating Depreciation Total after-tax
End of year cost cash flow cash flow Depreciation tax shield cash flow
0 –100 000 –100 000
1 20 000 14 000 20 000 6 000 20 000
2 30 000 21 000 20 000 6 000 27 000
3 34 000 23 800 20 000 6 000 29 800
4 40 000 28 000 20 000 6 000 34 000
5 20 000 14 000 20 000 6 000 20 000

At a discount rate of 12 per cent, the NPV is calculated as follows:

NPV = –100 000 + 20 000 / (1.12)1 + 27 000 / (1.12)2 + 29 800 / (1.12)3 + 34 000 / (1.12)4
+ 20 000 / (1.12)5

NPV = –100 000 + 17 857 + 21 524 + 21 211 + 21 608 + 11 349

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NPV = –$6451

Based on the above analysis, the project would be rejected. This analysis, however, is incorrect
because it applies a nominal discount rate to cash flows which are measured in real terms.
In addition, there is an inconsistency as the depreciation tax shield is in nominal terms whereas
other cash flows are reflected in real terms.

The correct procedure would be to convert the real cash flows given above into nominal terms
using the expected inflation rate. In this example, we assume that the expected inflation rate is
6 per cent per annum. The nominal before-tax operating cash flows would be modified to those
shown in Table 3.4. As the table shows, the nominal before‑tax operating cash flows are obtained
by adjusting the real cash flows from Table 3.2 by the expected inflation rate of 6 per cent.
That is, 21 200 = 20 000(1.06)1, 33 708 = 30 000(1.06)2 and so on. Table 3.3 shows these real and
nominal before-tax cash flows.

Table 3.3: Real and nominal before-tax cash flows

Real Nominal
before-tax before-tax
operating operating
End of year cash flow cash flow
1 20 000 21 200
2 30 000 33 708
3 34 000 40 495
4 40 000 50 499
5 20 000 26 765

We can now compute the total after-tax cash flows, as shown in Table 3.4.
 194 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Table 3.4: Cash flows expressed in nominal dollars—correct procedure

Nominal Nominal
before-tax after-tax Total nominal
Project operating operating Depreciation after-tax
End of year cost cash flow cash flow Depreciation tax shield cash flow
0 –100 000 –100 000
1 21 200 14 840 20 000 6 000 20 840
2 33 708 23 596 20 000 6 000 29 596
3 40 495 28 346 20 000 6 000 34 346
4 50 499 35 349 20 000 6 000 41 349
5 26 765 18 735 20 000 6 000 24 735

Using the 12 per cent nominal discount rate, and assuming a constant 30 per cent tax rate,
the correct NPV is:

NPV = –100 000 + 20 840 / (1.12)1 + 29 596 / (1.12)2 + 34 346 / (1.12)3 + 41 349 / (1.12)4
+ 24 735 / (1.12)5

NPV = –100 000 + 18 607 + 23 593 + 24 447 + 26 278 + 14 035

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NPV = $6960

The correct NPV is positive and so the project should be accepted. The consistent treatment
of the effects of inflation has resulted in accepting a project that would otherwise have
been incorrectly rejected.

As depreciation is based on historic rather than replacement cost, the depreciation tax shield is
fixed in nominal terms and therefore does not need to be adjusted in Table 3.4.

Note that rather than make the investment decision using the information in Table 3.4, which is
based on nominal cash flows, we could have used real cash flows discounted at the real
discount rate.

Based on the assumed expected inflation rate of 6 per cent, the corresponding real discount rate
is (1.12 / 1.06) – 1 = 5.66 per cent per annum. To obtain the real cash flows, it is necessary to modify
the information in Table 3.2 to allow for the fact that the depreciation tax shields shown there are
expressed in nominal terms. So, the real depreciation column in Table 3.5 is obtained by adjusting
the nominal depreciation by the expected inflation rate of 6 per cent per annum. For example,
18 868 = 20 000 / (1.06)1 and 17 800 = 20 000 / (1.06)2 and so on.

Table 3.5: Cash flows expressed in real dollars—correct procedure

Real Real
before-tax after-tax Real Total real
Project operating operating Real depreciation after-tax
End of year cost cash flow cash flow depreciation tax shield cash flow
0 –100 000 –100 000
1 20 000 14 000 18 868 5 660 19 660
2 30 000 21 000 17 800 5 340 26 340
3 34 000 23 800 16 792 5 038 28 838
4 40 000 28 000 15 842 4 753 32 753
5 20 000 14 000 14 945 4 484 18 484
 Study guide | 195

Discounting these real cash flows at the real discount rate of 5.66 per cent gives the following NPV:

NPV = –100 000 + 19 660 / (1.0566)1 + 26 340 / (1.0566)2 + 28 838 / (1.0566)3

+ 32 753 / (1.0566)4 + 18 484 / (1.0566)5

NPV = –100 000 + 18 607 + 23 593 + 24 447 + 26 278 + 14 035

NPV = $6960

As expected, this is the same as the NPV we obtained using nominal cash flows with the nominal
discount rate.

The depreciation tax shield has been adjusted to take into account the effect of inflation (i.e. in
real dollars). We can see that the ‘real’ value of the depreciation tax shield is reducing as each
year passes (as compared to the nominal value which remained at $6000 each year).

It should be noted that this example assumes that the expected inflation rate will remain
unchanged over the life of the project and affects all cash flows and the discount rate equally.
This is a necessary condition for real and nominal NPVs to be equal. If different inflation rates

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apply to different components of the project’s cash flow (e.g. labour costs might increase more
rapidly than sales revenues), the analysis would be carried out in nominal terms using specific
inflation rate forecasts.

The adjusted present value approach

Many managers will not feel comfortable with this module’s methodology of excluding interest
payments and the associated tax shields from the calculation of project cash flows. The exclusion
of interest tax shields was justified on the grounds that these effects are captured by using the
after-tax cost of borrowing in the calculation of WACC. However, WACC can only be used if the
following conditions apply:
• the company’s debt ratio remains constant, or that debt is a constant proportion of the
project’s value; and
• there are no other financing effects apart from interest tax shields.

In practice, these conditions often do not apply. Debt ratios will not be constant if the debt
component of a project is not rolled over at maturity; debt may be raised at a subsidised interest
rate; or there may be significant flotation costs associated with raising debt.

To enable these financing effects to be evaluated specifically, an alternative procedure known as

the adjusted net present value (APV) approach has been suggested. The APV approach is based
on the principle of value additivity. That is, the total value of a project is the sum of the value of
the various components which together comprise the overall project.

In essence, the APV starts with the assumption that the project being considered is financed
using only equity. It then discounts the after-tax operating cash flows at the discount rate
appropriate for the business (or operating) risk associated with the project. This results in the
‘base case’ NPV, which would be the actual NPV if the project were, in fact, undertaken by an
all‑equity financed company. The next step is to add the valuation implications of the financing
‘side effects’ associated with the project being considered. These include, but are not limited to,
the following:
• the present value of interest tax shields;
• flotation or capital raising costs; and
• the value of subsidised financing.
 196 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

There is no simple rule which says that the APV approach is better than the NPV approach,
or vice versa. It is important to understand when one method is more appropriate than the
other. The NPV approach (with WACC as the discount rate) is appropriate for projects which are
extensions of the company’s existing activities. That is, when the risk of the project is the same as
the risk of the company and the debt capacity of the project is the same as that of the company.
On the other hand, when projects are of a different business (or operating) risk and/or the debt
ratio is different from the company’s existing operations, the APV approach may be preferred.

You may now like to practise the techniques for project evaluation and selection by working
through various scenarios in the booklet ‘Project evaluation’ available on My Online Learning.
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 Study guide | 197

Case studies
This section presents three short case studies with the objective of reinforcing your
understanding of the study material presented earlier in this module. You are encouraged
to work through these case studies before checking the suggested answers.

Case Study 3.1: Tabtech Ltd

Katarina Wong is the managing director of Tabtech Ltd, a company that manufactures specialised
components for tablet computers. Katarina has a law and marketing background and established
Tab‑tech Ltd seven years ago. She has since built the company into a thriving business that employs
around 30 people and has an annual turnover of several million dollars. Katarina is considering
purchasing new manufacturing equipment to replace the existing equipment that is currently being
used at the main Tabtech facility. She has sought advice from a project analyst who has submitted a
report on the proposal. However, Katarina does not have time to review the report in detail and has
asked you to explain to her the executive summary section of the analyst’s report.
Executive summary
Using the company’s WACC of 19.5 per cent per annum, we calculate that the project’s NPV

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is $15 500. The IRR is 20 per cent and the payback period is only three years. Accordingly, it is
recommended that the new equipment be purchased.

She has also asked if you have any advice for her.

(a) Provide a detailed explanation of the executive summary to Katarina. Remember that she is
not experienced in these matters and does not understand the executive summary.
(b) What advice would you offer Katarina and why?

Case Study 3.2: Bollywood Dance Society of Victoria

Daniel Singh is the owner and manager of an 800-seat cinema in Victoria, Australia. Recently, he was
approached by the Bollywood Dance Society of Victoria to see whether he would be interested in
having the society perform a one-night-only concert at the cinema every two years. The first concert
will be scheduled almost immediately (year 0), with guaranteed repeat business in years 2 and 4. As the
society is an amateur group, the musicians are not paid but the cinema will have to meet all operating
costs, such as advertising, the wages of the ushers and electricity. In return, the cinema will retain all
the revenue from ticket sales. Knowing that there is a strong demand for Bollywood music in Victoria,
Daniel estimates that he will be able to sell 75 per cent of the tickets, of which two-thirds will be at the
standard price of $60 per ticket in year 0 and one-third at the premium price of $80 per ticket, also in
year 0. Ticket prices are then expected to increase at a rate of 5 per cent per annum. The operating
cost of a one-night concert is currently estimated to be $14 000 and these operating costs are expected
to increase at a rate of 6 per cent per annum. Daniel has been advised that if he decides to proceed
with the proposal he will need to make immediate improvements to the cinema’s acoustics at a cost of
$70 000. Such improvements are essential to attract a music-loving audience but will also attract some
extra cinema patrons and hence produce a small increase in the net cash inflows to the cinema side
of the business. The present value of these increased net cash inflows has been estimated at $25 000.

The nominal required rate of return for this proposal is 15 per cent per annum.

(a) Compute the proposal’s net present value.

(b) What advice would you give Daniel and why?

Note: Ignore tax issues and clearly state any assumptions that you to make in analysing
this proposal.
 198 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Case Study 3.3: ToyTech Ltd

ToyTech Ltd is a manufacturer of high-tech toys targeted at the teenage market. To finance its
operations, ToyTech Ltd uses a mix of ordinary shares and preference shares. The following information
has been extracted from ToyTech’s most recent statement of financial position.

Liabilities

12% bonds, $100.00 par value $12 000 000

Shareholders’ funds

14% preference shares, $10.00 par value $10 000 000

Ordinary shares, $2.00 par value $40 000 000

Retained earnings $15 000 000

Total shareholders’ funds $65 000 000

The bonds will mature in six years’ time and are currently trading at $88.65. They pay coupons annually
and a coupon has just been paid. The preference shares are currently trading at $8.75 while its ordinary
shares are currently trading at $3.50. ToyTech’s equity beta has been estimated as 1.8, the risk-free
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rate is 5 per cent and the market risk premium is 8 per cent. The management of ToyTech considers
that its present capital structure is appropriate for its financing requirements and it has no plans to
change its capital structure. Assume there are no company or personal taxes levied.

(a) Estimate ToyTech’s WACC (assuming no taxes).

(b) Under what circumstances is it appropriate for ToyTech to use this WACC as the hurdle rate
when evaluating its projects?
(c) ToyTech is considering a project which is in its usual line of business but will be financed
entirely by a new bond issue. A project team member argues that in this situation the
cost of debt should be used as the appropriate hurdle rate to evaluate this project.
What recommendation would you make and why?
 Study guide | 199

Review
In this module, we have extended our discussion of the management of funds which we started
in Module 2. In essence, this involves the commitment of the organisation’s financial resources
to various short-term and long-term assets, and the maintenance of an adequate funding base
through the company’s financing operations.

The focus of this module was the capital budgeting decision, which involves analysing the
after‑tax cash flows from investment proposals and determining whether, in present value terms,
these net cash flows exceed the initial investment. That is, whether the investment proposals
have positive NPVs. Other decision rules were shown to be inferior to the NPV rule. In the context
of what discount rate to use in evaluating these investment proposals, we examined the issues
related to estimating a company’s WACC and the limitations in its use.

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 Appendix 3.1 | 201

Appendix
Appendix

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Appendix 3.1
Review of financial mathematics

This appendix provides a review of how present and future values of single cash flows and series
of cash flows are computed. The review also applies present value concepts to common financial
management issues, including home mortgages and interest on bank deposits.

1. Future value of a single cash flow

Given the time value of money, a cash flow received in the current period (i.e. today, typically
referred to as ‘time 0’) is more valuable than a cash flow of the same nominal amount that is
received some time in the future. Accordingly, a cash flow of P0 today that earns interest at a rate
of r per cent per period for n periods has a future value of:

Fn = P0(1 + r)n (1)

Note that the term (1 + r)n gives us the future value of $1 today earning an interest rate of r per
cent per period for n periods.

Example
What is the future value of $1000 invested at an interest rate of 10 per cent per annum at the end
of three years?

Solution
The future value at the end of year 3 of $1000 invested today is:

F3 = 1000 (1 + 0.10)3 = $1331.

 202 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

2. Present value of a single cash flow

A similar principle applies in the determination of a present value equivalent of an expected cash
flow at some future date. Formally, a cash flow of Fn that is due in n periods and is discounted at
a rate of r per cent per period has a present value today of:

P0 = Fn / (1 + r)n (2)

Example
Compute the present value of $1331 obtained at the end of year 3, assuming an interest rate
of 10 per cent per annum.

Solution
The present value of $1331 realised at the end of year 3 is:

P0 = 1331 / (1 + 0.10)3 = $1000

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3. Future value of a series of cash flows

If we are given a series of cash flows occurring over different time periods, their future value can
be computed as the sum of the future values of each individual cash flow. That is, the future value
of the sum of a series of cash flows earning an interest rate of r per cent per period at the end of
n periods is equal to the sum of their individual future values.

Fn = C1(1 + r)n-1 + C2(1 + r)n-2 + … + Cn (3)

Note that in the above relation, we assume that the first cash flow occurs at the end of year 1
and the last cash flow occurs at the end of year n. Clearly, the cash flow occurring at the end of
year n will not earn any interest. If we assume that the first cash flow occurs at the end of year 0
(i.e. immediately), then the future value at the end of year n is:

Fn = C0(1 + r)n + C1(1 + r)n-1 + C2(1 + r)n-2 + … + Cn (3a)

Example
Compute the future value at the end of year 4 of the following cash flows: C1 = $100, C2 = $200,
C3 = $350, C4 = $300. Next, compute the future value at the end of year 4 of the following cash
flows: C0 = $100, C1 = $100, C2 = $200, C3 = $350, C4 = $300. Assume that the applicable interest
rate is 10 per cent per annum.

Solution
The future value of the first cash flow stream is:

F4 = 100(1.10)3 + 200(1.10)2 + 350(1.10)1 + 300

F4 = 133.10 + 242.00 + 385.00 + 300.00 = $1060.10

The future value of the second cash flow stream is:

F4 = 100(1.10)4 + 100(1.10)3 + 200(1.10)2 + 350(1.10)1 + 300

F4 = 146.41 + 133.10 + 242.00 + 385.00 + 300.00 = $1206.51

 Appendix 3.1 | 203

4. Present value of a series of cash flows

If we are given a series of cash flows occurring over different time periods, their present value can
be computed as the sum of the present values of each individual cash flow. That is, the present
value of a sum of a series of cash flows discounted at r per cent per period over n periods is
equal to the sum of their individual present values.

P0 = C1 / (1 + r)1 + C2 / (1 + r)2 + … + Cn / (1 + r)n (4)

If we assume that the first cash flow occurs at the end of year 0 (i.e. immediately), then the
present value is:

P0 = C0 + C1 / (1 + r)1 + C2 / (1 + r)2 + … + Cn / (1 + r)n (4a)

Example
Compute the present value of the following future cash flows: C1 = $100, C2 = $200, C3 = $350,
C4 = $300. Next, compute the present value of the following future cash flows: C0 = $100,
C1 = $100, C2 = $200, C3 = $350, C4 = $300. Assume that the applicable interest rate is 10 per cent
per annum.

MODULE 3
Solution
The present value of the first cash flow stream is:

P0 = 100 / (1.10)1 + 200 / (1.10)2 + 350 / (1.10)3 + 300 / (1.10)4

P0 = 90.91 + 165.29 + 262.96 + 204.90 = $724.06

The present value of the second cash flow stream is:

P0 = 100 + 100 / (1.10)1 + 200 / (1.10)2 + 350 / (1.10)3 + 300 / (1.10)4

P0 = 100 + 90.91 + 165.29 + 262.96 + 204.90 = $824.06

Note the relation between the future value computed in the previous example and the present
value computed above. Given the interest rate of 10 per cent per annum, if we know the future
value at the end of year 4 we can obtain the present value today as follows:

For the first cash flow stream we have:

P0 = Fn / (1 + r)n = 1060.10 / (1 + 0.10)4 = $724.06

For the second cash flow stream we have:

P0 = 1206.51 / (1 + 0.10)4 = $824.06

 204 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

5. Present value of an annuity

An annuity is a series of equal cash flows occurring over n periods. Ordinary annuities occur
at the end of each period. The first cash flow of an ordinary annuity is assumed to occur at the
end of the first period, and the last cash flow occurs at the end of period n. The following is a
derivation of the formula for valuing an ordinary annuity.

The present value of an annuity is calculated as:

P0 = A / (1 + r)1 + A / (1 + r)2 + … + A / (1 + r)n (5)

Letting R j = 1 / (1 + r) j, we have:

P0 = AR1 + AR2 + … + ARn (5a)

Also, by multiplying equation (5a) through by R1, we have:

P0R1 = AR2 + AR3 + … + ARn + ARn + 1 (5b)

Subtracting equation (5b) from equation (5a) we get:

MODULE 3

P0 – P0R1 = AR1 – AR n + 1 (5c)

P0 = A[R1 – Rn + 1] / (1 – R1)

Substituting for R, we have:

P0 = A{[1 – (1 + r)–n] / r } (5d)

Note that in equation (5d), P0 is the present value today of the cash flow series, and the first
cash flow of the annuity A occurs at the end of period 1. The full derivation of this formula is
outside the scope of the subject study materials.

Example
You have a choice between accepting $6000 today and an equal annual cash flow of $1000 per
year at the end of each of the next 10 years. What should you do if the interest rate is 10 per cent
per annum?

Solution
We need to compare the lump sum amount available today with the present value of the 10-year
annuity of $1000 per year. The present value of this annuity is:

P0 = 1000{[1 – (1.10)–10] / 0.10} = $6144.57

So, you would prefer the annuity of $1000 per year, since it has a higher present value than the
lump sum of $6000 today.
 Appendix 3.1 | 205

6. Present value of a perpetuity

A perpetuity is an annuity that recurs forever. Note that as n approaches infinity in equation (5d)
we have:

[1 – (1 + r)–n] / r approaches 1 / r

So, the present value of a perpetuity is given by the following simple expression:

P0 = A / r (6)

Example
Your company can lease a parcel of land for an equal annual payment of $20 000 per year
forever, or purchase it today for $210 000. The first payment is to be made at the end of year 1,
with subsequent payments being made at the end of each year. If the interest rate is 10 per cent
per annum what should the company do?

Solution

MODULE 3
We need to compare the lump sum amount available today with the present value of the $20 000
per year perpetuity. The present value of this annuity is:

P0 = 20 000 / 0.10 = $200 000

So, the company would prefer to lease the land since it has a lower cost in present value terms.

7. Present value of a growing perpetuity

A perpetuity of A dollars today growing at a constant rate of g per cent per period has the cash
flow stream A (1 + g), A (1 + g)2, … A(1 + g) n and so on. Note that the first cash flow is A (1 + g)
and not A. In obtaining the present value of a growing perpetuity at time 0 we do not include the
time 0’s cash flows. The present value of this growing perpetuity is:

P0 = A (1 + g)1 / (1 + r)1 + A (1 + g)2 / (1 + r)2 + … + A (1 + g)n / (1 + r)n + … (7)

Letting R j = (1 + g) j/(1 + r) j, we have:

P0 = AR1 + AR2 + … + ARn + … (7a)

Also, by multiplying equation (7a) by R1, we have:

P0R1 = AR2 + AR3 + … + ARn + 1 + … (7b)

Subtracting equation (7b) from equation (7a) we get:

P0 – P0R1 = AR1 (7c)

P0 = AR1 / (1 – R1)

Substituting for R, we have:

P0 = A (1 + g) / (r – g) (7d)

As noted, equation (7d) assumes that the cash flow at time 1 is A (1 + g). In addition, we also
need to assume that r > g.
 206 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Example
Your company can lease a parcel of land for an annual lease payment of $16 000 next year,
with lease payments increasing at a constant annual rate of 2 per cent forever, or purchase
it today for $210 000. Assuming an interest rate of 10 per cent per annum, what should
the company do?

Solution
A cash flow of $16 000 next year implies that A(1 + g) = $16 000. The present value of this
perpetuity growing at 2 per cent per annum is:

P0 = 16 000 / (0.10 – 0.02) = $200 000

The company would prefer to lease the land because the cost is lower in present value terms.

8. Future value of an annuity

The future value at the end of period n of an n-period annuity is derived in a similar manner
to the present value of an annuity, as follows.
MODULE 3

Fn = A (1 + r)n – 1 + A (1 + r)n – 2 + … + A (1 + r)1 + A (8)

Letting L j = (1 + r) j, we have:

Fn = ALn – 1 + ALn – 2 + … + AL1 + AL0 (8a)

Also, by multiplying equation (8a) through by L1, we have:

Fn L1 = ALn + ALn – 1 + … + AL2 + AL1 (8b)

Subtracting equation (8a) from equation (8b) we get:

Fn L1 – Fn = ALn – AL0 (8c)

Fn = A[Ln – 1] / (L1 – 1)

Substituting for L, we have:

Fn = A[(1 + r)n – 1] / r (8d)

Example
If you save an equal annual cash flow of $2000 per year (starting next year) for the next 10 years,
how much would you have at the end of 10 years, assuming an interest rate of 10 per cent per
annum? What equivalent amount would you need to save and invest today so that you are able
to withdraw $2000 every year for the next 10 years?
 Appendix 3.1 | 207

Solution
The amount available at the end of year 10 is the future value of the $2000 saved every year over
that period. That is:

F10 = 2000[(1.10)10 – 1] / 0.10 = $31 874.85

There are two methods that can be used to compute the equivalent amount needed today to be
able to withdraw $2000 every year for the next 10 years. The first method is to simply compute
the present value of the future value computed above. That is:

P0 = 31 874.85 / (1 + 0.10)10 = $12 289.13

Alternatively, we can compute the present value of the $2000 annuity to obtain the same present
value as:

P0 = 2000{[1 – (1.10)–10] / 0.10} = $12 289.13

9. Mortgage repayments

MODULE 3
In a standard, fixed-rate mortgage, a lump-sum cash flow (the loan amount) is exchanged for
equal, periodic (usually monthly) payments over the duration of the mortgage. Each payment
equals the sum of the interest payment and principal repayment. This is a specific application of
the formula for the present value of an ordinary annuity.

Calculating periodic payments

Assume P0 is borrowed today at an interest rate of r per cent per period to be repaid in n equal
payments of A dollars per period. Since the periodic payment is an n-period annuity, we can use
equation (5d) to compute A. That is:

P0 = A{[1 – (1 + r)-n] / r } (9a)

Rearranging the above expression to solve for the periodic payment, A, we get:

A = r × P0 / [1 – (1 + r)-n] (9b)

Example
A 25-year home loan for $100 000 has a monthly interest rate of 1 per cent and payments are to be
made at the end of each month. Compute the monthly payment on this loan.

Solution
In this case, n = 25 × 12 = 300 months.

Monthly payment, A = r × P0 / [1 – (1 + r)–n]

So, A = 0.01(100 000) / (1 – 1.01–300)

= 1000 / 0.9494655

= $1053.22.

The process of discounting the monthly payment essentially ‘strips off’ the interest component
from each month’s payment. We can therefore use equation (9a) to calculate the principal
balance at the end of any time period.
 208 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Example
Assume a 25-year home loan for $100 000 has a monthly interest rate of 1 per cent and payments
are made at the end of each month. Compute the principal balance remaining at the end of the
first year of the loan.

Solution
The principal balance remaining at the end of the first year (after 12 months) is the present value
of the remaining 288 (= 300 – 12) monthly payments. That is:

P12 = 1053.22[1 – (1.01)–288] / 0.01 = $99 324.59

Calculating interest payment, principal repayment and principal remaining

The dollar interest paid in any period is calculated as the per period interest times the principal
balance at the start of that period, which is equal to the principal balance at the end of the
previous period. The principal repaid in any period is calculated as the monthly payment less
the dollar interest paid in that period. The principal remaining in any period is the previous
period’s principal less the principal repaid in this period.
MODULE 3

In the above example, the interest and principal repaid in the first month is:

Interest paid = 0.01(100 000) = $1000.

Principal repaid = 1053.22 – 1000 = $53.22.

The principal balance at the end of the month = 100 000 – 53.22 = $99 946.78.

The loan’s amortisation schedule for the first three months of the loan period is as follows.

Previous
Total Principal period’s Principal
Month payment Interest repaid principal remaining
(1) (2) (3) = (5) × 1% (4) = (2) – (3) (5) (6) = (5) – (4)
0 — — — — $100 000.00
1 $1053.22 $1000.00 $53.22 $100 000.00 99 946.78
2 $1053.22 999.47 53.75 99 946.78 99 893.03
3 $1053.22 998.93 54.29 99 893.03 99 838.74

Note that of the first month’s payment of $1053.22, about 95 per cent goes towards
paying interest and only 5 per cent goes towards repayment of principal. As the principal
remaining reduces over time, the proportion of the monthly payment going towards paying
interest decreases and the proportion of the monthly payment going towards repaying the
principal increases.
 Appendix 3.1 | 209

Example
Compute the total interest paid, principal repaid and the year-end principal balance for the
first 12 months of the loan in the previous example.

Solution
Beginning principal = $100 000.

Principal remaining at the end of the first 12 months, P12 = 1053.22[1 – (1.01)–288] / 0.01 = $99 324.59.

Total principal repaid during the first 12 months = 100 000 – 99 324.59 = $675.41.

Total payments made during the first 12 months = 12 × 1053.22 = $12 638.64.

Total interest paid during the first 12 months = 12 638.64 – 675.41 = $11 963.23.

10. Effective interest rates

Much of the foregoing discussion assumes that interest is paid annually. However, this is often not

MODULE 3
the case. In the mortgage example, interest is paid on the monthly principal balance outstanding.
Although the monthly interest rate in our mortgage example was 1 per cent, the effective annual
interest rate is not 12 per cent because interest on the loan is computed (i.e. compounded) more
frequently than once a year.

The effective annual interest rate will differ from the nominal (or quoted) annual interest rate as
long as interest is computed more often than once a year.

If the stated annual interest rate is r per cent and interest is computed m times a year,
the per period interest rate is r / m per cent and the effective annual interest rate is calculated as:

re = (1 + r / m)m – 1 (10)

The above expression means that if we invest $1 at the quoted annual interest rate of r per
cent, but where interest is compounded m times during the year, our initial $1 investment will
amount to $(1 + r / m)m by the end of the year. The effective annual interest rate would be as in
equation (10). Note that if interest is calculated once a year (m = 1), then re = r.

Note that in Australia the market convention for daily compounding is to use 365 days in
computing the effective annual interest rate. This differs from some other markets, such as the
United States and Japan, where the market convention for daily compounding is to assume that
there are 360 days in the year. In such cases, the divisor for the daily compounding calculation
would be 360 and not 365.

Continuous compounding
The compounding interval becomes continuous as m approaches infinity, which is often assumed
in financial asset pricing applications, giving:

(1 + r / m)m approaches e r

where the exponential constant, e = 2.718281.

With continuous compounding, the effective interest rate is computed as:

re = e r – 1 (11)
 210 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Example
You are considering depositing $10 000 in one of the following banks. The interest rates offered
by these banks and the compounding intervals are as follows.

Annual interest rate (%) Compounding interval

Bank A 6.10 Annual
Bank B 6.00 Semi-annual
Bank C 5.95 Monthly
Bank D 5.90 Daily (365-day basis)
Bank E 5.85 Daily (360-day basis)
Bank F 5.92 Continuous

Which bank offers the best interest rate?

Solution
The effective annual interest rates are:

Bank A: re = 6.100% p.a.

MODULE 3

Bank B: re = (1 + 0.0600 / 2)2 – 1 = 6.090%.

Bank C: re = (1 + 0.0595 / 12)12 – 1 = 6.115%.
Bank D: re = (1 + 0.0590 / 365)365 – 1 = 6.077%.
Bank E: re = (1 + 0.0585 / 360)360 – 1 = 6.024%.
Bank F: re = e 0.0592 – 1 = 6.099%.

So, Bank C offers the best effective annual interest rate.

Question A3.1
Assume that the interest rate is 10 per cent per annum and that all cash flows occur at the end of
each year. Round off your final answers to the nearest dollar.
(a) Suppose you decide to invest $50 000 today. Compute the total value of your investment at
the end of 10 years.
(b) Your friend also decides to invest $50 000 but plans to do so in instalments. Specifically,
she will invest $5000 now, $10 000 at the end of year 1, $15 000 at the end of year 2,
and $20 000 at the end of year 3. Compute the total value of her investment at the end
of 10 years.
(c) Another friend of yours also decides to invest $50 000 but to defer the investment until
the end of year 3. Compute the total value of his investment at the end of 10 years.
(d) Now assume that you and your friends have an investment time horizon of 10 years.
What additional amount would your friends have to invest today so that, at the end
of year 10, the total value of their respective investments is the same as the total value
of your investment?
(e) Suppose that, instead of investing the additional amounts today in part (d), your friends
decide to invest funds in equal annual amounts over the 10-year period. Compute the
amounts that the two friends would now need to invest.
(f) Now suppose that you and your friends decide to invest funds in equal annual amounts
over the 10-year period so each of you has the same total value at the end of 10 years as
computed in part (a). What would this equal annual amount be?
 Appendix 3.1 | 211

Question A3.2
Suppose you decide to invest $120 000 today for a five-year period at an interest rate of 8 per cent
per annum.
(a) Compute the value of your investment at the end of year 5, assuming that interest is
compounded annually.
(b) Suppose that the amount invested earned interest compounded on a monthly basis. If you
wanted the value of your investment at the end of year 5 to be the same amount as that
computed in part (a) then what amount would you need to invest today?
(c) What is the effective annual interest rate that you are earning on your investment in part (b)?
(d) Suppose you decide to invest $24 000 at the end of every year for the next five years rather
than the $120 000 today. Compute the value of your investment at the end of year 5 if interest
is compounded on (i) annually and (ii) monthly.

MODULE 3
MODULE 3
 Suggested answers | 213

Suggested answers
Suggested answers

MODULE 3
Question 3.1
(a) The net present value (NPV) can be computed as follows:

NPV = 200 000 / (1.15)1 + 250 000 / (1.15)2 + 250 000 / (1.15)3 – $480 000

NPV = 527 328 – 480 000

NPV = $47 328

As the NPV is positive, the company should invest in this project.

(b) By paying $480 000 for this project, the company gives up $480 000 in cash and in return
invests in a project yielding cash flows with a present value estimated to be $527 328.
The increase in the company’s value is the difference between these two amounts, that
is, the project’s NPV of $47 328. This amount also represents the increase in shareholders’
total wealth.

(c) The internal rate of return (IRR) can be computed by setting the NPV to zero and solving
for the unknown IRR in the following relationship:

NPV = 0 = 200 000 / (1 + IRR)1 + 250 000 / (1 + IRR)2 + 250 000 / (1 + IRR)3 – 480 000

Using trial and error and interpolation as discussed in the study guide (or a financial
calculator), we obtain the IRR as 20.6 per cent.

As the IRR is greater than the required rate of return of 15 per cent the company should
invest in this project.
 214 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

(d) Annual depreciation = 480 000 / 3 = $160 000

So, the annual profits are:

Year 1: 200 000 – 160 000 = $40 000

Year 2: 250 000 – 160 000 = $90 000
Year 3: 250 000 – 160 000 = $90 000

Total profits = 40 000 + 90 000 + 90 000 = $220 000

Average annual profit = 220 000 / 3 = $73 333

Accounting rate of return = 73 333 / 480 000 = 15.3%

(e) The project recovers $450 000 in the first two years and the remaining $30 000 during the
third year. Assuming the future cash flow is evenly distributed over year 3, the payback period
can be computed as:

Payback period = 2 + (30 000 / 250 000) = 2.12 years

MODULE 3

(f) The company should accept the project because its NPV is positive and the IRR is higher than
the discount rate. Note that the payback period is higher than the threshold of two years and
the accounting rate of return is lower than the threshold of 20 per cent. These criteria would
imply rejecting the project. However, these two methods have serious flaws, as discussed in
detail in the study guide, and the company should accept the project based on the NPV or
IRR methods.

Question 3.2
(a) The IRR for Proposal C is the same as for Proposal B because C is just double the size of B.

The net present values for Proposal C are twice the amount for Proposal B because
Proposal C is twice the size of Proposal B. So the NPV at 9 per cent is $90 128 and the NPV
at 11 per cent is $40 718.

(b) The NPV profiles and crossover points for the three proposals are as follows.

400 000

300 000

200 000
Crossover point (A and C)
Net present value ($)

100 000 Crossover point (B and C) and IRRB and IRRC

IRRA Discount
0 rate (%)
4 8 12 16 20 24 28
NPVA
–100 000
NPVB

–200 000
NPVC
–300 000
 Suggested answers | 215

(c) (i) At 9 per cent, Proposal C has the highest NPV and Proposal A has the highest IRR.

(ii) At 11 per cent, Proposal A has the highest NPV and the highest IRR.

(iii) At a required rate of return of 11 per cent, the IRR method gives a result consistent with
the NPV method, as Proposal A’s IRR exceeds the IRRs for Proposal B and Proposal
C, and Proposal A’s NPV is also the highest. At a required rate of return of 9 per cent,
there is a conflict because Proposal C has the highest NPV, while Proposal A has the
highest IRR. The conflict between the IRR and NPV methods arises because 9 per cent
and 11 per cent fall on either side of the crossover point for Proposal A and Proposal C as
shown in the graph. As detailed in the study guide, the IRR can give us misleading results,
which means the NPV criteria would be preferable.

Question 3.3
(a) The NPVs of the costs associated with the two machines are as follows:

NPV of Machine X’s cost = 400 000 + 50 000[1 – (1.10)–7] / 0.10 = $643 421

MODULE 3
NPV of Machine Y’s cost = 450 000 + 40 000[1 – (1.10)–9] / 0.10 = $680 361

(b) Your assistant is correct in saying that the machine with the lower net present value of costs is
preferable. However, the assistant is incorrect if the decision is to choose Machine X because
the two machines do not have the same project lives. Machine X lasts for seven years,
while Machine Y lasts for nine years. In comparing the two machines the company needs to
consider what it will do at the end of year 7 if it accepts Machine X over Machine Y. This is
because Machine X lasts for two fewer years than does Machine Y.

(c) One method that can be used to evaluate the two machines is to assume that the machines
will be replaced with themselves until a common time horizon is achieved for the two
machines. However, this would involve computing the NPVs of nine investments in Machine
X and seven investments in Machine Y to give a common time horizon of 63 years. Clearly,
it would be easier to assume that the machines will be replaced forever and use the constant
chain of replacement assumption to obtain the NPVs as follows.

Step 1
Calculate the NPV of each project over its estimated life. Here, Machine X’s NPV is
$643 421 and Machine Y’s NPV is $680 361.

Step 2
Convert these NPVs to an equivalent annual annuity (EAA) series. The present value
annuity factors for the two machines are:

Machine X’s present value annuity factor = [1 – (1.10)–7] / 0.10 = 4.8684

Machine Y’s present value annuity factor = [1 – (1.10)–9] / 0.10 = 5.7590

So, the EAAs of the two machines are:

Machine X’s EAA = 643 421 / 4.8684= $132 162

Machine Y’s EAA = 680 361 / 5.7590= $118 138

 216 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

Step 3
Using the EAAs, the NPVs can be obtained as follows:

Machine X’s NPV = 132 162 / 0.10 = $1 321 620

Machine Y’s NPV = 118 138 / 0.10 = $1 181 380

So, the company would prefer to invest in Machine Y rather than Machine X because it has
a lower net present value of costs. Note: Other qualitative considerations may be important
(such as the risk of changes in technology), in which case the machine with the shorter life
may be preferred.

In NPV analysis, we typically use negative figures for cash outflows and positive figures for
cash inflows. In this question, all cash flows for both machines are cash outflows (i.e. both
the initial and the recurring costs). The NPV calculations in this question would therefore
typically be completed using negative figures (reflecting the fact that they are all cash
outflows), in which case, the highest NPV would be accepted. However, in this question,
the calculations have been completed using positive figures, which results in the lowest NPV
‘of costs’ being accepted. Either method is acceptable, so it is important to be aware of the
MODULE 3

actual cash flows taking place, as well as the NPV that is being calculated.

Question 3.4
The cost of debt (bonds) is given as 12 per cent (before tax). To compute the after-tax WACC
we need to compute the after-tax cost of debt, which is:

k*d = kd (1 – τ )

k*d = 0.12 × (1 – 0.30) = 8.4%

The cost of preference shares on an after-tax basis can be computed using the following
pricing relationship:

P0 = Dp / kp

The market price of preference shares is given as $4.00. The face value of the preference shares
can be obtained from the balance sheet. There are 5 000 000 preference shares on issue which
have a total face value of $50 000 000, implying a face value per share of $10. The dividend
per share paid on these shares is:

Dp = 0.06 × 10 = $0.60

So, kp = Dp / P0 = 0.60 / 4.00 = 15%

The cost of equity (ordinary shares) on an after-tax basis can be estimated from the security
market line as:

rf + [ E (rm ) − rf ]βe
ke =

ke = 0.06 + (0.10 × 1.2)

ke = 18%
 Suggested answers | 217

The market value of each bond is equal to the present value of the future coupon payments and
the face value at maturity:

Market value of each bond = C × [1 – (1 + kd )–n] / kd + Fn / (1 + kd )n

= 100[1 – (1.12)–5] / 0.12 + 1000 / (1.12)5

= 360.48 + 567.43

= $927.91

The book value of the bonds is $60 000 000, which means there are 60 000 (= 60 000 000 / 1000)
bonds outstanding. Applying the market value to these bonds calculates their total value
as follows:

Total value of the bonds = 927.91 × 60 000

= $55 674 600

MODULE 3
The market value of preference shares = 5 000 000 × 4.00 = $20 000 000

The market value of ordinary shares = 20 000 000 × 5.00 = $100 000 000

After-tax WACC

The after-tax WACC is:

After-tax WACC
Source Market value Market weight Cost (Market weight × Cost)
Bonds $55 674 600 0.317 0.084 0.0266
Preference shares $20 000 000 0.114 0.150 0.0171
Ordinary shares $100 000 000 0.569 0.180 0.1024
Total $175 674 600 1.000 0.1461

That is, Bland’s after-tax WACC is 14.61 per cent.

Case Study 3.1: Tabtech Ltd

(a) The project was evaluated using the company’s WACC of 19.5 per cent, which is the discount
(or hurdle) rate appropriate for evaluating projects that are similar to the typical projects in
which the company normally invests funds.

Using this WACC, the net present value was estimated at $15 500. The net present value is a
summary measure that is computed by subtracting the present value of all cash outflows from
the cash inflows associated with the project. The NPV also measures the dollar value that is
expected to be added to the overall value of the company if this project is accepted.

The internal rate of return is 20 per cent, which is the rate of return that the company is
expected to earn over the life of the project. It is the return that, by definition, makes the net
present value of the project equal to zero.

The project’s payback period is three years, which implies that it is expected to take three
years for the project’s initial outlay to be recovered.
 218 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

(b) As the project’s NPV is positive based on the quantitative measures, the project can be
accepted, subject to you being comfortable with the assumptions. It should be noted,
however, that one needs to be careful in concluding that the project should be accepted,
as the IRR is very close to WACC. This implies that this project’s NPV is slightly greater than
zero, indicating that this is, at best, a marginal project. The payback period is relevant only
in the context of a threshold payback period, which has not been provided in the executive
summary. More importantly, even if a threshold payback period was provided one would
prefer not to use it in evaluating the project given the problems associated with this method,
as discussed in the study guide.

Case Study 3.2: Bollywood Dance Society

of Victoria
Cash flows in year 0

Initial outlay = $70 000 (given).

MODULE 3

Tickets expected to be sold = 0.75 × 800 = 600.

Revenue on tickets expected to be sold at $60 = 2 / 3 × 600 × 60 = $24 000.

Revenue on tickets expected to be sold at $80 = 1 / 3 × 600 × 80 = $16 000.

Total cash inflow from ticket sales in year 0 = 24 000 + 16 000 = $40 000.

Present value of increased net cash flows from improvements = $25 000 (given).

Operating cash outflow in year 0 = $14 000 (given).

Total cash inflow in year 0 = 40 000 + 25 000 – 14 000 – 70 000 = –$19 000.

Cash flows in year 2

As both ticket prices are increasing at the same rate, the total cash inflow in year 2 is:

Total cash inflow in year 2 = (24 000 + 16 000) × (1.05)2

Total cash inflow in year 2 = $44 100.

The operating cash outflow of $14 000 is expected to increase by 6 per cent per annum.
So the cash outflow in year 2 is:

Cash outflow in year 2 = 14 000 × (1.06)2 = $15 730.

Cash flows in year 4

As both ticket prices are increasing at the same rate, the total cash inflow in year 4 is:

Total cash inflow in year 4 = (24 000 + 16 000) × (1.05)4

Total cash inflow in year 4 = $48 620.

 Suggested answers | 219

The operating cash outflow of $14 000 is expected to increase by 6 per cent per annum.
So the cash outflow in year 4 is:

Cash outflow in year 4 = 14 000 × (1.06)4 = $17 675.

A summary of the cash inflows, outflows and net cash flows is as follows:

Year Cash inflows Cash outflows Net cash flows

0 40 000 + 25 000 14 000 + 70 000 –19 000
2 44 100 15 730 28 370
4 48 620 17 675 30 945

(a) The net present value is:

NPV = –19 000 + 28 370 / (1.15)2 + 30 945 / (1.15)4.

NPV = –19 000 + 21 452 + 17 693.

NPV = $20 145.

MODULE 3
(b) The proposal has a positive NPV, indicating that it should be accepted.

Case Study 3.3: ToyTech Ltd

(a) In order to compute WACC, we need to compute the cost of each capital component as well
as its market value.

The cost of bonds can be computed using trial and error in the following pricing expression:

=P0 C 
d (
 1 − (1 + k ) − n )  + Fn
 kd  (1 + kd )n
 

=
 1 − (1 + k )−6
88.65 12 
d ( )  + 100
 kd  (1 + kd )6
 

Using trial and error, the cost of bonds, kd = 15.0%.

The market value of bonds is the number of bonds multiplied by the price per bond, that is:

Number of bonds = 12 000 000 / 100 = 120 000

Market value of bonds = 120 000 × 88.65 = $10 638 000.

The cost of preference shares can be computed using the following pricing expression:

Dp
P=
kp

1.40
8.75 =
kp

Cost of preference shares, kp = 1.40 / 8.75 = 16.0%.

 220 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

The market value of preference shares is the number of preference shares multiplied by their
price per share, that is:

Number of preference shares = 10 000 000 / 10 = 1 000 000

Market value of preference shares = 1 000 000 × 8.75 = $8 750 000.

The cost of ordinary shares can be computed using the CAPM expression, as follows:

Cost of ordinary shares, ke = 0.05 + (0.08 × 1.8) = 19.4%.

The market value of ordinary shares is the number of ordinary shares multiplied by their price
per share, that is:

Number of ordinary shares = 40 000 000 / 2 = 20 000 000

Market value of ordinary shares = 20 000 000 × $3.50 = $70 000 000.

The market value of the company is the sum of the market values of each financing
component, that is:
MODULE 3

Market value of the company = 10 638 000 + 8 750 000 + 70 000 000 = $89 388 000.

The cost of capital is computed by weighting each financing component’s cost with its
proportion in the capital structure, as follows ($ ’000s):

 10 638   8750   70 000 

k 0 = 0.15   + 0.16   + 0.194  
 89 388   89 388   89 388 

k0 = 18.54%.

(b) ToyTech can use WACC if: (i) the proposed project is the same risk as its ‘average project’
(typically, a project in its usual line of business), and (ii) the current financing mix will continue
to be used after the project is undertaken. That is, the project will not alter the company’s
financial risk.

(c) The bondholders will not limit their claim to those cash flows that are generated by the
particular project. They will lay claim to all cash flows generated by the company, up to
the return they have been promised. So, it is incorrect to restrict the WACC calculation to
the cost of debt. As long as the two criteria in part (b) are met, the company should use its
WACC to evaluate the project. Note that it is likely that ToyTech would recalculate its WACC,
incorporating the new debt issue.

Question A3.1
(a) The future value at the end of n years of your investment is:

Fn = P0(1 + r )n

So, F10 = 50 000 (1 + 0.10)10 = $129 687

 Suggested answers | 221

(b) The future value at the end of 10 years of this friend’s investment can be computed as the
sum of the future values of the individual cash flows. The first cash flow will earn interest over
10 years, the second over nine years and so on, as follows:

F10 = 5000 (1.10)10 + 10 000 (1.10)9 + 15 000 (1.10)8 + 20 000 (1.10)7 = $107 676

(c) In this case your friend earns no return for the first three years and the value of the $50 000
invested over the remaining seven years is as follows:

F10 = 50 000 (1.10)7 = $97 436

(d) From part (a), the total value of your investment at the end of 10 years is $129 687.

Let the additional amounts invested today by your friends be $X and $Y, respectively.

We need the future value of the first friend’s investment to be worth $129 687 once the
additional amount of $X invested today is included in the answer from part (b). That is:

129 687 = 107 676 + X (1.10)10

MODULE 3
So, X = (129 687 – 107 676) / 1.1010 = $8486

Similarly, for the second friend, we need the future value of his investment to be worth
$129 687 once the additional amount of $Y invested today is included in the answer from
part (c). That is:

129 687 = 97 436 + Y (1.10)10

So, Y = (129 687 – 97 436) / 1.1010 = $12 434

(e) From part (4), we know that the amounts your two friends need to invest today are $8486 and
$12 434, respectively. To obtain the equal annual amounts that they should invest rather than
these lump sum amounts, we need to convert these amounts today into annuities using the
present value of an annuity, which is:

P0 = C [1 – (1 + r )–n] / r

So, the equal annual amount that the first friend needs to invest (C1) can be computed as:

C1 = P0 / {[1 – (1 + r )–n] / r }

C1 = 8486 / {[1 – (1.10)–10] / 0.10}

C1 = $1381

Similarly, the equal annual amounts that the second friend needs to invest (C2) can be
computed as:

C2 = 12 434 / [1 – (1.10)–10] / 0.10

C2 = $2024
 222 | INVESTMENT EVALUATION AND CAPITAL STRUCTURE

(f) The future value at the end of 10 years that we need is $129 687 from part (1). To obtain the
equal annual amounts that should be invested over the 10-year period we need to use
the future value of an annuity, which is:

Fn = C [(1 + r )n – 1] / r

So, the equal annual amount that needs to be invested (C ) is:

C = Fn / {[(1 + r )n – 1] / r}

C = 129 687 / {[(1.10)10 – 1] / 0.10}

C = $8137

Question A3.2
(a) The future value of the amount invested at the end of year 5 is:
MODULE 3

F5 = 120 000 (1 + 0.08)5 = $176 319

(b) With monthly compounding, the amount you need to invest today will be less than $120 000
because interest is compounded on a monthly, rather than annual, basis. The amount you
would need to invest today is the present value of $176 319 taking into account monthly
compounding where the monthly interest rate is 0.6667% (= 8% / 12) and the total time
horizon is 60 months (= 5 × 12). That is:

Pk0 = 176 319 / (1 + 0.08 / 12)5 × 12 = $118 347

(c) The effective annual interest rate is computed as:

re = (1 + r / m)m – 1

So, re = (1 + 0.08 / 12)12 – 1

re = 8.3%

(d) (i) The future value of the $24 000 annual annuity where interest is compounded on an
annual basis involves using the future value of an annuity, which is:

Fn = C [(1 + r )n – 1] / r

 (1 + 0.08)5 − 1
= =
F5 24 000   $140 798
 0.08 

(ii) To compute the future value of the $24 000 annual annuity where interest is compounded
on a monthly basis we need to use the effective annual interest rate of 8.3 per cent from
part (c) rather than the stated interest rate of 8 per cent because interest is compounded
on a monthly, rather than annual, basis while the annuity occurs annually. The future
value is:

(1 + 0.083)5 − 1
F5 =
24 000 × =
$141 643
0.083
 References | 223

References
References

MODULE 3
Fama, E. F. & French, K. R. 1992, ‘The cross-section of expected stock returns’, Journal of Finance,
vol. 47, pp. 427–66.

Fama, E. F. & French, K. R. 1993, ‘Common risk factors in the returns on stocks and bonds’,
Journal of Financial Economics, vol. 33, pp. 3–56.
MODULE 3
 FINANCIAL RISK MANAGEMENT

Module 4
DERIVATIVES
PETER HUMPHREY AND RICHARD ALLAN
 226 | DERIVATIVES

Contents
Preview 227
Introduction
Objectives
The role of derivatives in financial risk management 228
Extent of derivatives use
The three main categories of derivatives
Implications of derivatives use for risk management
Earnings at risk (EAR) and value at risk (VAR)
Risk appetite
Basis risk
Key concepts and definitions
IFRS 13 Fair Value Measurement
Forwards 237
Foreign exchange forward contracts
Trading process
Interest rate forwards
Forward price of commodities
Contango and backwardation in commodity forward markets
Futures 243
Trading process
Swaps 244
Economic equivalence
The relevance of economic equivalence
Interest rate swaps
Options 248
Option pricing
Other option terminology
MODULE 4

Hedging using options

Determinants of option premium
Uses in hedging
Exotic derivatives and hybrids 257
Tailored or exotic options
Derivatives on other assets 258
Credit derivatives
Energy and other derivatives
Carbon market and derivatives
Weather derivatives
Managing the counterparty component of credit risk
and operational risk 260
Counterparty risk—estimations using credit value adjustments
Centralised clearing
Operational risk governance
Review 263

Suggested answers 265

References 267
Optional reading
 Study guide | 227

Module 4:
Derivatives
Study guide

Preview
Introduction

MODULE 4
This module is intentionally titled ‘Derivatives’ rather than the much more restrictive ‘Financial
derivatives’. This is because financial derivatives tend to be associated with providers rather than
users of risk management tools. Real, credit and commodity derivatives will also be covered,
albeit in less detail than the standard currency and interest rate derivatives.

This module is followed by both Module 5 ‘Interest rate risk management’ and Module 6
‘Foreign exchange risk management’. Modules 5 and 6 apply the concepts outlined in this
module to the two major areas of financial risk management faced by most companies.

Objectives
By the end of this module you should be able to:
• explain what is meant by ‘derivatives’ and the role of derivatives in financial risk management;
• describe the four main classes of derivatives;
• explain the basis on which derivatives are priced and valued; and
• describe exotic derivatives and hybrids.
 228 | DERIVATIVES

The role of derivatives in financial

risk management
Extent of derivatives use
In a financial sense, risk is viewed as the chance of variation or volatility in value.

Risk can be an opportunity or a threat—and boards of directors require their risk managers to
both increase profits from favourable movements in revenues or reduce costs related to financial
exposures as well as to adequately control unfavourable movements.

The key to risk management is to trade off risk and return, not simply to eliminate exposures
to commodity and financial markets. Furthermore, this trade-off should be understood and
approved by the board of directors.

It is commonly agreed that financial derivatives constitute less than 10 per cent of the total
derivatives to which an organisation is exposed. Less than 10 per cent of Australian companies
state that they use options or derivatives. However, the real number using derivatives is likely to
exceed 80 per cent because the majority of derivatives influencing companies are in the form
of real options (explained below) and commercial options, such as pricing clauses, re‑pricing
clauses, warranties, ceiling/floor pricing agreements, currency-related price-adjustment
clauses and so on. These have exactly the same effect on the commercial outcome of an
organisation’s activities as financial derivatives purchased from banks and other financial
institutions. For effective risk management, these real and commercial options need to be
identified and quantified. Often real and commercial options could be replicated with financial
derivatives, but are in many cases either cheaper or more effective than financial instruments.
MODULE 4

This is why it is important to both identify and to price them.

If management does not properly identify or price these embedded options, serious errors of
judgment can occur. An example of this is the AWA case (covered in Module 1), where AWA
directors swore on oath that their exposures were around AUD 200 million, while the existence
of embedded options put their actual exposures as low as AUD 40 million.

Risk management is about enhancing opportunities and limiting or eliminating threats. Such
management involves the financial risk manager seeking solutions in both the commercial sector,
for primary risk management through real options and by contract and commercial negotiation,
and in the finance sector for secondary risk management through the use of the spectrum of
financial markets and instruments.

The three main categories of derivatives

There are three main groups of derivatives:
1. real derivatives (real options);
2. commercial options; and
3. financial derivatives.

1. Real derivatives (real options)

A real option is an ability derived from a business situation or commercial contract or from
access to external support (such as government intervention). Real options can greatly affect the
valuation of investments as they enable organisations to vary their strategies or exposures with
a view to adding value or removing risk. Real options include the right (but not the obligation)
to vary an investment or contract or to opt out of a proposed scheme or project (e.g. to invest in
a European country if it withdraws from the European Union).
 Study guide | 229

As real options are a proxy for risk, they tend to increase in value with volatility or uncertainty.
Unlike commercial options, they may not be able to be sold separately from the business
because of their nature.

In Australia, a good institutional example is the real option effect of the government’s ‘Four Pillars’
banking policy on the real value of each of the banks concerned. While neither the government
nor the Reserve Bank provides official lender-of-last-resort status to any of the four banks
concerned, its implied presence gives them immense market advantage.

Other examples of real options are:

1. Timing options. The option of determining when an investment is undertaken—such as the
option to delay buying a business in a country town about to be bypassed by a new freeway
until the effect on business is clearer.
2. Exit options. The option to abandon a project if demand does not materialise, or if the
environmental liability appears too large—such as on the introduction of carbon restrictions
on some industries.
3. Operating options. The option to adjust operations during times of strong or weak demand
or to shift production globally—as is commonly done in the motor vehicle industry, when
production varies between production plants in separate countries because of exchange
rate fluctuations.

In terms of the risk management process outlined in Module 1 and replicated here as Figure 4.1,
real options should be considered in all four sub-categories under ‘Stage 2—Identify exposures’.
However, this module will not attempt to quantify their effect due to the complexity of such
valuation.

MODULE 4
2. Commercial options
Commercial options are those that relate to commercial contracts where there is a right to adjust
the terms and conditions of that contract. Commercial options are also called ‘synthetic derivatives’
as they exhibit the main pay-off characteristics of derivatives but are embedded in commercial
contracts. Financial risk managers must take these into consideration as an alternative to financial
derivatives—they may be cheaper or more effective than the financial products. While they can
often be identified, priced and sold as if they were financial derivatives, they are not considered as
financial instruments because there is no financial institutional counterparty.

As noted in Module 1, embedded commercial options include:

• repricing clauses;
• ceiling/floor price arrangements;
• inflation/CPI adjustments; and
• on-costing.

3. Financial derivatives
The Reserve Bank of Australia’s website glossary defines a derivative as:
A financial contract whose value is based on, or derived from, another financial instrument (such as
a bond or share) or a market index (such as the Share Price Index). Examples of derivatives include
futures, forwards, swaps and options (RBA 2014).

Forward and futures contracts are financial contracts that oblige the buyer and seller to buy or
sell an asset at an agreed price at an agreed future date.

A swap is a financial contract that requires two parties to exchange cash flows from one asset for
cash flows from another asset.
 230 | DERIVATIVES

An option is a financial contract that gives the option buyer the right but not the obligation to
buy or sell an asset at an agreed price at or before an agreed future date.

Some examples of common financial derivatives are:

• forward foreign exchange contracts;
• interest rate swaps;
• stock options;
• credit default swaps; and
• commodity futures, such as sugar or oil.

These financial derivatives are the main focus of this module.

Figure 4.1: The specific financial risk management process

Establishing the context

1. Set the core criteria

Stakeholder Functional Business/Industry Key strategic

expectations currency drivers objectives

Apparent exposures

Risk identification
2. Identify exposures

Internal Embedded Timing Commercial

MODULE 4

offsets options mismatches adjustments

Actual exposures

Risk analysis
3. Determine the risk factors

Interest Foreign Commodity

Liquidity Funding Credit Operating
rates exchange (FX) price

(Goal setting) Risk-adjusted exposures

Risk evaluation
4. Appraise risks

Probabilities/
Tolerances Contingencies Project
Consequences

Benchmarked exposures

Risk treatment 5. Manage risks

(treasury operations)

Money
FX Capital Equity Derivative Investment Hybrid
market

Ongoing communication, review and consultation

 Study guide | 231

Implications of derivatives use for risk management

Once identified and quantified, virtually any financial or commercial risk can be managed—
at a price. Almost any risk can be adjusted, increased or eliminated over a wide range of
timeframes and financial periods in a great range of currencies using either commercial markets
(largely through contracts) or financial instruments and markets.

The benefits of lower risk include:

• Higher share price. Lower volatility in profit and/or statement of financial position should
lead to a more stable share price, and many shareholders are willing to pay a premium for a
more stable share price.
• Better credit quality. Lower financial volatility means lower credit risk to financiers and
therefore makes the company more attractive to financiers to provide funding.
• Cheaper debt. Less risk to financiers should also translate to a lower cost of debt
(although this may be offset to some extent if the gearing level is increased).

The outcome achieved after using a derivative product can either be:
• fixed or known regardless of market rate at maturity; or
• structured to provide an outcome dependent on movements in a specified benchmark.

Derivatives rarely require the full face value of the contract to be paid when the deal is
struck. For example, in the case of a sugar futures contract, a buyer of 50 tonnes of sugar at
USD 240/tonne, does not have to pay the market value of the sugar—USD 12 000—because
the settlement date of the contract is in the future. Instead, the buyer need only pay an initial
margin, for example, USD 800.

Properly used to manage underlying exposures, derivatives should normally have the effect of

MODULE 4
reducing a company’s overall risk.

However, because up-front costs are normally a fraction of the principal amounts involved,
derivatives can also be used to leverage risk, which, when used by speculators, can and often
has led to either large profits or large losses. The losses have given derivatives a reputation as
risky and dangerous instruments. Warren Buffett famously said of derivatives:
We view them as time bombs, both for the parties that deal in them and the economic system
(Buffett 2003, p. 13).

In the financial markets, where risk is priced and traded, the proliferation of derivatives turnover
proved to be a catalyst for trade—but sometimes allowing trading to excess. For example,
the huge increase in the size of the credit derivative market led in 2007 to a major liquidity crisis
in the subprime and associated derivatives markets. This crisis required hundreds of billions
of dollars to be injected into the global financial system by the central banks. The financial
system continued in crisis for the next 12 months, culminating in the bankruptcy of the major
US investment bank Lehman Brothers in September 2008 and the triggering of further credit
crises in many countries around the world, including Iceland, Ireland, Greece and Italy.

Thus, as with all financial instruments, derivatives need to be fully understood if they are to be
used effectively. As a result of this, derivatives have their own accounting standard—IAS 39:
Financial Instruments: Recognition and Measurement. A new standard on financial instruments,
IFRS 9 Financial Instruments, is currently being phased in to replace IAS 39. This phasing in
process is discussed fully in Module 7. The starting point under IAS 39 is that unrealised gains and
losses on derivatives must be recognised through profit and loss. In some circumstances, when a
derivative proves to be an effective hedge, the gain or loss can be recorded in equity, or the
offsetting gain or loss on the underlying asset may also be recognised through profit and loss.

The introduction of this standard led to a heightened awareness of derivatives by the accounting
profession. Both management and accounting executives need to be fully cognisant of the
nature and valuation of derivatives and their use in hedging financial risks.
 232 | DERIVATIVES

Earnings at risk (EAR) and value at risk (VAR)

A key part of the risk management process is having a monitoring system to quantify financial
risk in a commercial context. Two common and to an extent complementary techniques and
measures of risk are ‘earnings at risk’ and ‘value at risk’.

Earnings at risk (EAR)

Earnings at risk (EAR) is a metric which measures the quantity by which net income is estimated
to change in the event of an adverse change in currency and/or interest rates. It is a risk
measurement which is closely linked with value at risk (VAR) calculations—although VAR
calculates changes in the entire (usually fair value) value of an investment or derivative portfolio
with its consequent risk of loss. EAR is a cash flow estimate (profit and loss; P&L) and VAR is
a stock estimate (statement of financial position).

EAR is linked to expected or budgeted earnings (i.e. the statement of profit or loss and other
comprehensive income) or cash flows and the possible deviation of earnings over defined time
frames or horizons (commonly in groups of quarters or yearly). For example, where a company
has yearly earnings of $1 million and an earnings risk of $250 000, the expectations are that
earnings in the first year time horizon can deviate upwards to $1 250 000 or down to $750 000.

EAR scenarios are generally calculated by using a variation of:

Principal amount × Interest × Time period = Interest income and interest expense.

However, most EAR models will also allow for the addition of other factors, such as short-term
rates, long-term rates and credit risk spreads. There are also other items linked to interest income
MODULE 4

and expenses, such as credit days outstanding, working capital balances and interest rates
received or paid.

Earnings at risk lends itself to sensitivity analysis and the comparison of variables. A typical
EAR model will provide analysis for up to a 200–300 basis point increase or fall in interest rates.
These may also be shown as a single rise/fall, or gradual change in rates.

Value at risk (VAR)

Value at risk (VAR) estimates the probability of the size of a future financial loss using specified
levels of confidence, normal risk distributions and expected portfolio values. Outcomes vary
according to the underlying statistical market assumptions.

In VAR analysis, risk is defined by reference to ‘unrealised’ market values of a portfolio. VAR
defines risk as the mark-to-market loss on a fixed portfolio (of instruments and/or derivatives)
over a fixed time horizon, assuming normal markets and no trading in the portfolio. For example,
if a portfolio of derivatives held has a one-day 2 per cent VAR of $1 million, there is a 0.02
probability (or confidence) that the portfolio will fall in value by more than $1 million over the
24‑hour period if there is no trading carried out. In other words, a loss of $1 million or more on
this portfolio is expected in one day out of 50 days (2% probability).

Both EAR and VAR techniques are used by boards to help visually and quantitatively assess
both the dollar values at risk to the organisation and the likelihood of those quantified dollar
risks. They do not drive risk appetite (or risk policy), but measure and describe the financial
range and consequence for a given appetite for risk, whether it be with a portfolio of assets or
liabilities or for project analysis. The focus of the modelling could, along the lines of worst case,
predict expected outcomes and/or a combination of the two.
 Study guide | 233

Reporting EAR and VAR

Models also can be used to cover a range of financial instruments. This is where a diagram such
as a ‘tornado’ chart (as shown in Figure 4.2) can assist management in understanding the overall
position of an organisation. In the tornado chart below, the financial instruments are ordered so
that the largest bar appears at the top of the chart, the second largest appears second from the
top, and so on—to resemble the side profile of a tornado.

Figure 4.2: Tornado chart of effects of financial variables on expected earnings

$ million
0 5 10 15

Cash interest rate Low

FX rate (AUD/USD) High

Long bond rates

Option volatility

The chart shows the effect of various financial variable changes on the expected earnings of an
organisation, with the base expected earnings being $7 million. As illustrated, any changes in
the cash interest rate result in a range of potential outcomes from a low of $4 million to a high
of $12 million.

MODULE 4
Tornado charts are also discussed in more detail in Module 8.

Risk appetite
One of the key criteria set out in Stage 1 of the financial risk management process (Figure 4.1)
is stakeholder expectations, which includes the determination of the stakeholders’ appetite
for risk. This varies from practically none, in the case of, for example, trustee companies
and many not‑for-profits, to highly leveraged risk‑takers such as hedge funds or venture
capital organisations.

If either the risk of default or the consequences of default are underestimated, the results can,
and in many cases have, proved catastrophic. Consider the following two examples:

Example 4.1: S
 ociété Générale Jérôme Kerviel—loss of
USD 7.16 billion (2008)
Société Générale futures trader Jérôme Kerviel, 31, devised a series of fake transactions to conceal
unauthorised trades that resulted in estimated direct losses of over USD 7 billion. The trader had taken
a position that markets would fall, but then changed his position at the beginning of 2008 that they
would rise. In court, his defence was that bonuses were so large that his superiors gave at least tacit
approval to his excessive trading—underestimating both the implied market risks and the consequences
of market price volatility.
 234 | DERIVATIVES

Example 4.2: J P Morgan Chase—loss of over

USD 3 billion (2012)
In May 2012, JP Morgan Chase disclosed that a trading group had suffered ‘significant’ losses in a
portfolio of credit investments initially estimated at USD 2 billion. Within a week of the disclosure,
the losses were re-estimated to exceed USD 3 billion. The losses gained momentum, fuelling an
even more rapid deterioration in the underlying financial liabilities of the bank—an example of an
underestimation of the consequences of default, or credit risk.

It should be noted that commodity risk can also result in high risks, with consequent large losses
if matters get out of control. For example, in the mid-1990s Sumitomo tried to corner the global
market for copper and spent billions buying metal to boost its price. In 1996, the Japanese
financial institution announced losses of USD 2.6 billion which had been built up over 10 years.
In Australia, the Pasminco AUD 3.4 billion losses in 2001 is another example.

Credit default swaps played a major role in the US sub-prime mortgage crises that was triggered
in 2007. A credit default swap (CDS) is a financial instrument that permits the buyer to protect
themselves in the event the issuer of that security defaults—or by speculators, who are effectively
taking a position that the issuer of the securities will indeed go out of business (much like hedge
funds in currency markets who effectively take a position on a devaluation of a currency).

In the US up to the start of 2007 there was little incidence of companies defaulting. The issuers—
mainly banks—would therefore take in premiums and for the most part not have to pay out on the
largely mortgage-based securities that they had insured through CDSs. The size of the premiums
reflected the low probability of default assumed by the market. These incorrectly priced securities
encouraged excessive speculation, which resulted in what is now referred to as the sub-prime
mortgage crisis of 2007–10.
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In summary, risk appetite varies greatly, and those willing to accept considerable risk expect
commensurate returns. However, if correctly priced, on a risk-adjusted basis, an investor
should be indifferent to low-risk, low-return investments or high-risk, high‑return investments.
This is theoretically correct, but fails in periods of shock or crisis, when the consequences of
underestimating volatility have proven to be disastrous for many individuals, organisations and
even countries.

Basis risk
Basis risk is another risk associated with imperfect hedging when using derivatives. It arises as a
result of the difference between the value of the asset whose current price is being hedged and
the price of the asset underlying the derivative (hedge). Basis risk can also arise as a result of a
mismatch between the maturity date of the derivative used and the actual selling or delivery date
of the asset being hedged. In this case, the hedge mismatch occurs when the spot price of the
asset to be hedged and the hedging instrument price do not converge on the maturity date of
the derivative. The amount by which the two prices differ measures the value of the basis risk.
That is,

Basis risk = Spot price of hedged asset – price of hedging instrument

Basis risk will be discussed in more detail in Module 6 (on foreign exchange and commodity
risk management) where basis risk is quite common and often involves futures contracts.
There are other types of basis risks (in commodity markets) which arise as a result of futures or
derivative contracts for delivery at different locations. This mismatch of the delivery location of
the underlying derivative with the derivative’s settlement location is known as ‘locational basis
risk’ or ‘geographical basis risk’. An example is the basis price difference or risk of Australian
retail oil prices and the closest related futures price for oil in Singapore.
 Study guide | 235

These basis risks can be actively managed or passively accepted. While clearly it is ideal to have
a perfectly correlated hedge, in commercial reality, it is often more efficient to simply assume the
basis risk or seek to minimise the basis risk by using a portfolio of instruments and derivatives
that most closely approximate the underlying risk. Where this is inadequate or not possible,
more sophisticated techniques which take into account the basis risk’s volatility to determine
the ideal dollar risk (or ‘delta’) of the hedge may need to be used.

There are other types of basis risk, for example ‘product basis risk’, where an asset or
commodity price risk position is hedged with futures or derivatives of similar but different
products—such as the hedging of a corporate bond with a government bond futures contract.
Where assets are hedged with futures contracts that deliver to different dates, an additional
‘calendar basis risk’ exists.

Basis risks are also present in the energy and commodities markets and this will be discussed
in Module 6.

Key concepts and definitions

Three key concepts and terms need to be defined prior to examining the derivative products
themselves. These are:

1. Spot rate
The spot rate is the price or value of the benchmark on the day of the transaction. This is the rate
normally quoted in the media—such as the foreign exchange spot rate between the US dollar
and the Australian dollar. For a spot rate agreed today, the foreign exchange cashflows will be

MODULE 4
transferred normally two clear business days later.

AUD (commodity currency)/USD (terms currency) = 0.8000 means AUD 1.0000 can be exchanged
for 80.00 US cents or 0.8000 US dollars.

The commodity or ‘base’ currency is the currency shown on the left-hand side of the equation
of a quote and the terms or pricing currency is shown on the right-hand side of the quote.
The commodity currency is fixed and the terms currency is the fluctuating number, or price.

For example, AUD/USD indicates that the commodity being traded is the AUD (as it is on the
LHS) and it is priced in terms of the USD. Therefore, AUD/USD 0.8289 means that one Australian
dollar equals 0.8289 US dollars or, more commonly, 82.89 US cents.

Example 4.3
Export Co. has entered into an agreement today, Wednesday, to sell USD 10 million ‘spot’ at a rate
of AUD/USD 0.8000. This means that Export Co. will receive AUD 12.5 million on delivery of the
USD 10 million.

Calculation: 10 000 000 / 0.8000 = 12 500 000

 236 | DERIVATIVES

2. Value date
The value date is the date on which the cash or other means of payment is transferred. In the
case of most foreign exchange spot deals, this is two business days after the trade date. Thus a
sale of USD against AUD done on a Wednesday would involve a transfer of funds on the Friday.

Therefore, in Example 4.3, the actual cash transfers for the spot deal would take place on
the Friday.

The reason value dates and spot dates are often different is to allow both parties to confirm
details and organise the required funds transfer.

3. Forward or outright date

Forward purchases and sales are settled on a future date. The forward value date can be
anywhere from the day following the spot date to 10 years or more in the future. The forward
price is the price paid or received on the forward value date.

The forward settlement or value date is the day on which funds or underlying goods
are physically transferred.

IFRS 13 Fair Value Measurement

The impact on fundamental market prices of the economic downturn following the 2008 GFC
highlighted the need to improve the transparency of fair value measurements through disclosures
that give insight into measurement uncertainty. Following the events of 2008, the partial breakdown
of traded markets highlighted the importance of having common fair value measurements and
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disclosure requirements in both IFRS and US GAAP sets of accounting standards.

In response, IFRS 13 Fair Value Measurement came into effect on 1 January 2013 with the
International Accounting Standards Board (IASB) and US Financial Accounting Standards Board
(FASB) both creating a uniform framework to improve the consistency of fair value measurement
and requirements for entities around the world and across the IFRSs that use fair value.

IFRS 13 is nearly identical to the US GAAP standard (ASC 820, formerly Statement of Financial
Accounting Standards (SFAS) No. 157 Fair Value Measurements). IFRS 13 thus represents a
significant step forward in the application of fair value in financial reporting in general and to
financial instruments and derivatives in particular.

The IFRS 13 standard does not dictate which assets or liabilities are at fair value, only providing
guidance for measuring fair value when other standards require it. Before IFRS 13, fair value
measurement and disclosure requirements were dispersed throughout the range of international
financial reporting standards. IFRS 13 provides consistent fair value measurement guidance
across nearly all asset and liability classes on the statement of financial position.

Shortly after IFRS 13 came into effect, the IASB made additional tentative decisions in
March 2013. One of those decisions was that the fair value measurements of an investment
comprising quoted financial instruments should be the product of the quoted price of the
instrument times the quantity held. In the absence of unit of account guidance to the contrary,
fair value measurements should thus be consistent with how market participants would transact
in their economic best interest.
 Study guide | 237

IFRS 13 can be practically applied in various ways, including a) the markets approach, b) net
income approach and c) the adjusted net income approach. In dealing with non-quoted equity
instruments, for instance, where there is no ‘market price’ for the equivalent equity, or no identical
or comparable instrument, then the next best correct fair valuation of the instrument would be to
take a comparable company valuation multiple together with its performance measure (e.g. price–
earnings ratios) and apply the valuation technique to the non-quoted instrument.

An important benefit of IFRS 13 is that it has increased the transparency of fair values reported
in the financial statements. In particular, the standard clarifies which fair values are based on
quoted market prices and which are derived from models. It has particular relevance with respect
to complex derivative financial instruments, such as collateralised sub-prime debt obligations
which exhibit price opaqueness and difficulty in valuation.

The additional information about the assumptions used when fair values are measured using
models gives investors and analysts a better understanding of the relative subjectivity of
the measurement and the key value drivers. This helps fair value measurements to be made
consistently, and have a single and clear objective, and in doing so they provide information
about not only the measurements but also the level of subjectivity around those same fair values.

IFRS 13 ‘Fair Value Measurement’ is also discussed in the ‘Financial Reporting’ subject of the
CPA Program.

Forwards
A forward contract is a derivative contract between two parties, one of which is usually a financial

MODULE 4
institution, to exchange a financial product or the value of an index or other benchmark at an
agreed rate on a specified future date. This provides a guaranteed exchange of the underlying
asset at a known date for a specified amount or quantity.

Foreign exchange forward contracts

A company that needs foreign currency to pay for imports could enter into a forward exchange
contract (FEC) to buy an agreed amount of the foreign currency. A company that receives foreign
currency would enter into a contract agreeing to sell the foreign currency on the forward date in
exchange for the local currency. Once the FEC is agreed, it is an obligation for both parties to
deliver the agreed currency.

The forward price of an asset or commodity is sometimes incorrectly regarded as a forecast of

the spot price at the time of settlement. This is a misunderstanding in the case of most financial
derivatives, as the forward rate is derived from other market rates, not forecasts. For example,
in the case of foreign exchange (to continue Example 4.3), the price of the FEC is not based on
forecasts of the direction of the exchange rate. It is calculated with reference to the interest rates in
both currencies and the date of delivery. As all are known at the time the contract is entered into,
no forecasting is necessary.
 238 | DERIVATIVES

The following formula is used to calculate this FEC rate:

 spot (1 + (It × D / Y ) ) 
Forward rate =  
 1 + (Ib × D / Y ) 

Where:
spot = spot exchange rate.
It = interest rate of the terms currency (USD in the AUD/USD currency pair).
Ib = interest rate of the base currency (AUD in the AUD/USD currency pair).
D = number of days from the spot value date to the forward value date.
Y = number of days in year. This will vary with the currency1.

The base or commodity currency is the currency shown on the left-hand side (LHS) of the equation
of a quote and the terms (or pricing) currency is shown on the right-hand side (RHS) of the quote.
In the example below of AUD/USD = 0.7847, the base currency is AUD and the terms currency is
USD. The base currency is fixed (generally ‘1’, although for the Japanese yen it is ‘100’) and the
terms currency is the fluctuating number, or price.

Example 4.4
The above formula can be used to calculate the FEC rate for any date and currency pair.
In this example the following applies:
Time period: 180 days
Spot rate: AUD/USD 0.8000
USD interest rate: 1.5 per cent per annum using a 360-day convention for US rates and
AUD interest rate: 5.5 per cent per annum using a 365-day convention for Australian rates2.
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Calculation of outright forward rate:

 0.8000 × (1 + ( 0.015 × 180/360 ) ) 

Forward rate =  
 1 + ( 0.055 × 180/365 ) 

= AUD/USD 0.7847

Note that in the calculation there is no forecasting required.

In the language of Module 3, the net present value (NPV) of the forward outright rate is in fact the
spot rate (at the time the rate is first calculated), although the bank will normally add a profit margin
as well into the price.

If any price is quoted other than that obtained using current spot rates and interest rates, arbitrage
(see the Glossary on MYOL) will occur to profit from such mispricing. An example may assist.

Example of price arbitrage

The forward price of an asset that is widely held as an investment is not a function of a
forecast but of the yield of the asset and the prevailing interest rate. Probably the most widely
held investment asset is cash and the most commonly traded forward is the forward foreign
exchange contract. To illustrate why forward prices aren’t based on forecasts, consider the
forward AUD/USD price quoted by ABC Bank.

1&2
The ‘day count’ or ‘Y’ is based on a convention. There are several different day count conventions
in financial markets, but for the purposes of this subject it is important to remember that the
United Kingdom, Canada, Australia and New Zealand use a 365-day count, while the United States
and the eurozone use 360 days. The 360-day year was originally devised for ease of use, treating each
month as having 30 days (30 days × 12 months = 360 days).
 Study guide | 239

The current spot price is 0.8000. ABC’s forward foreign exchange (FX) dealer believes that the
AUD will depreciate against the USD and in one year the price will be at 0.7500. This price is
offered to the market.

The market arbitrageur can borrow or lend AUD for one year at an interest rate of 8 per cent
and USD at 3 per cent. A risk-free profit can be made in these circumstances. The process would
be as follows:

USD cash Exchange AUD cash

Date flow rate flow

Borrow AUD 1250 for one year @ 8% Today 1250

Buy USD 1000 @ 0.8000 exchange rate with a 1000 0.8000 (1250)
spot FX deal

Lend USD 1000 for one year @ 3% (1000)

Repay AUD 1250 plus AUD 100 interest +1 year (1350)

Receive back USD 1000 plus USD 30 interest 1030

Implicit exchange rate in the repayment and receipt 0.7630

Sell USD to ABC @ 0.7500 (1030) 0.7500 1373

Profit 0 23

The implicit exchange rate of 0.7630 is the rate achieved through buying USD ‘spot’, lending the
USD and borrowing the AUD. The rate is the ratio of net USD and AUD cash flows: 1030 / 1350 =
0.7630. In this example, the arbitrageur could buy AUD forward from ABC at 0.7500 and sell the

MODULE 4
AUD forward, by way of the spot foreign exchange, borrowing and lending, at 0.7630.

This transaction would provide the arbitrageur $23 profit per $1000 or $23 000 profit per
$1 000 000. Other arbitrageurs would take advantage of this opportunity and drive the forward
FX price towards the implicit exchange resulting from the spot FX deal, loan and deposit.

This interest rate differential forward price model holds true for all investment assets. The asset
yield can take different forms—the dividend yield in the case of stocks, the coupon rate in the
case of bonds—but the forward price model as a function of the spot price, the asset yield and
the cash interest rate remains valid.

Trading process
It is highly recommended that companies get at least two quotes for all financial transactions
involving derivatives in order to provide a degree of assurance that the rates offered are
competitive. Once a company has a credit limit with a financial institution that trades currencies,
the company simply contacts the bank to state which currency it wishes to buy or sell and the
maturity date required. The bank(s) will quote the rate and, once agreed, the company has
its FEC. No money changes hands until the forward (or settlement) date, at which time the
currencies are exchanged.

It should be noted that derivatives such as FECs can create significant ‘real exposure’ while
having no up-front costs. As a result, companies should manage this risk of overexposure by
establishing internal controls to manage the risk of using derivatives. AWA Ltd, for example,
had over AUD 1 billion in open FECs when it discovered that its treasury manager was effectively
speculating in currency movements.
 240 | DERIVATIVES

➤➤Question 4.1
Your chief executive officer notes that forward AUD/USD rates are lower than current rates but
that a year ago they were higher than current rates. He says this follows because the forecast
rise in Australian rates has happened and everyone now expects the Australian dollar to fall.
Do you agree or disagree? Why?

Interest rate forwards

Interest rate forwards are a different, less obvious kind of forward contract. A forward interest
rate contract to borrow (pay interest) or lend (receive interest) at an agreed rate is a contract
to borrow or lend that begins on a future date with an agreed term to maturity. The derivative
interest rate forward contract will rarely result in the contracted parties actually borrowing and
lending the principal amount. Instead, the difference in interest cost between the agreed rate
and the then current rate at the future date is settled in cash, at the start of the reference period.

The most common form of interest rate forward contract is the forward rate agreement (FRA).
One party agrees to pay a fixed rate for a defined term—often three or six months, with the
term to commence at an agreed future date. For example, if a borrower agrees to pay a fixed
rate of 5 per cent on $1 million using a six-month versus nine-month FRA, then the borrower has
locked in that interest rate of 5 per cent for a three-month period beginning in six months’ time.
If the three-month market interest rate in six months’ time (i.e. the start date of the three-month
reference period) is higher than 5 per cent, the fixed-rate payer receives the difference between
5 per cent and the market rate, on the start date of the reference period. If the market rate is less
than 5 per cent, the fixed rate payer pays the difference.

This style of cash settlement is a common feature of derivatives. A derivative contract can lead
MODULE 4

to an exchange of face-value amounts on maturity—as is the case with a forward FX deal for
instance—but often leads to a cash settlement of the difference between the agreed rate or price
and a reference rate or price at maturity, as was the case with the above FRA.

It should be noted that, for the purposes of this subject, candidates will not be required to be
able to calculate the price of an FRA.

Forward price of commodities

The drivers behind the forward price of a commodity are quite different from those on investment
assets. Commodities are things such as base metals used in manufacturing and agricultural
commodities. While the investment asset price arbitrageur is happy to hold the asset to achieve
a profit, the purchaser of a commodity most often wants to consume it. Often the nature of the
asset itself makes it very difficult for the arbitrageur to hold the asset. Agricultural commodities
often spoil and cannot be held, that is, they have a limited shelf life. It is far more difficult to
hold and store base metals compared to investment assets. Consider the examples in Figures 4.3
and 4.4.
 Study guide | 241

Figure 4.3: London Metal Exchange official prices curve for aluminium

2250
2200
2150
2100
2050
Offer price
2000
1950
1900
1850
1800
1750
14/08/2012 09/11/2012 18/12/2013 17/12/2014 16/12/2015

The forward curve shows the seller price only for aluminium.

Source: London Metal Exchange 2012, ‘LMF official prices curve’, accessed October 2012,
http://www.lme.com/aluminiumalloy.asp.

Figure 4.4: InterContinentalExchange (ICE) Sugar No. 11 Futures

21.80

MODULE 4
21.60
Sugar price in USD cents per pound

21.40

21.20

21.00

20.80

20.60

20.40

20.20
Oct 12

Dec 12

Feb 13

Apr 13

Jun 13

Aug 13

Oct 13

Dec 13

Feb 14

Apr 14

Jun 14

Aug 14

Oct 14

Dec 14

Feb 15

Apr 15

Jun 15

Futures contract month

Compared to investment assets, commodity forward prices are driven by more complex supply,
demand, storage and spoilage issues—note the falling prices for sugar futures.
 242 | DERIVATIVES

Contango and backwardation in commodity forward markets

Like the foreign exchange market, commodities can be traded in the spot market (i.e. two days
forward) or using forward contracts (i.e. > two days forward). In investment asset markets the
forward price is determined by interest rate differentials. In commodity markets this is not
necessarily the case. The terms contango and backwardation are used to describe the forward
price of a commodity in relation to the spot price.

Contango is used to describe the situation when the forward price of a commodity exceeds
the current spot price. Contango is normal for a non-perishable commodity that has a cost of
carry—that is, a cost of holding a position. These costs will include warehousing fees and interest
forgone on money tied up, less income from leasing out the commodity if possible (e.g. gold).

Backwardation is used to describe the situation when the forward price of a commodity is
lower than the current spot price. This can occur when the spot price increases sharply due
to temporary supply disruptions or a temporary increase in demand and the markets expect
the price of the commodity to fall over time. It also occurs when new harvests are expected
to boost future stocks and markets to move into surplus. Natural disasters can also affect
prices. For example, during 2005 the spot oil price rose sharply due to increased demand from
China and supply disruptions from Hurricane Katrina, causing the oil futures market to move
into backwardation.

Contango and backwardation are also discussed in Module 6.

Example 4.5: Hedging an aluminium exposure

Significant changes in exchange rates also take place. The AUD rates have been inverted, because
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exporters benefit from a rising USD and falling AUD. This is now reflected in the graphs below, with
positive moves in both commodity and currency reflected in upward movements of the series.)

Aluminium versus AUD/USD, January 2000 to January 2011

3500 2.3
USD/AUD (RHS) 2.1
3000 1.9

1.7
USD per tonne

2500
USD/AUD

1.5

1.3
2000
1.1

1500 0.9
ALU in USD (LHS) 0.7
1000 0.5
Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11
 Study guide | 243

Futures
Futures are a standardised contract where the grade and delivery characteristics are specified
and the credit or counterparty risk is virtually eliminated as they are traded on an exchange.
They are contracts to buy or sell through a central party for a specified amount of a specified
asset on a specified date at a specified location for an agreed amount.

Futures do not require the use of a line of credit, compared to forward contracts, which are
traded over-the-counter (OTC). The market is open to virtually anyone who wishes to hedge or
speculate and can be accessed with the provision of an initial cash or security deposit.

The disadvantage is that futures may involve frequent requests for cash injections (margin calls),
which could be daily, and involve an uncertain drain on liquid funds. The requirement for margin
calls, together with the inability to tailor futures to match a company’s exposures, means that
OTCs are more commonly used by non-financial companies to hedge rather than using futures.
However, these limitations are mitigated by the ability to close out any open or ‘live’ futures
contracts virtually on request.

Trading process
Futures are traded on futures exchanges, which operate in all major economies—the United States
had 17 until the GFC, which resulted in the merging of some of the major exchanges in New York
and Chicago.

While some futures exchanges still have floor traders using an open outcry system, the great

MODULE 4
majority of futures trading is computer-based.

In Australia, the Sydney Futures Exchange (SFE) was the 10th-largest derivatives exchange in
the world until it merged with the Australian Securities Exchange (ASX) in 2006. Now it is the
ASX which provides futures and options trading (computer-based rather than floor trading,
or open outcry, on the four most actively traded markets—interest rates, equities, currencies
and commodities, including wool and cattle. Its most active products are:
• SPI 200 futures contract—futures contracts on an index of the largest 200 stocks on the ASX;
• AU 90-day Bank Accepted Bill Futures—Australia’s equivalent of T-Bill futures;
• three-year Bonds Futures—futures contracts on Australian three-year bonds; and
• 10-year Bonds Futures—futures contracts on Australian 10-year bonds.

The ASX trades futures over the ASX 50, ASX 200 and ASX property indexes, and over grain,
electricity and wool.

The clearing house interposes itself as counterparty to each trade and guarantees that the trade
will be settled as originally intended. This process is called novation.

The clearing houses charge two types of margins: an initial margin and a variation margin.
The initial margin is the collateral deposited by the futures buyer or seller to the clearing house
to cover possible future losses in the positions over a short (say, two-day) period. The variation
or mark-to-market gain or loss is a margin based on daily changes in the value of the contracts.

Firms or individuals have a single margin account with their broker and the change in value of
their positions is added to or deducted from their margin account daily.
 244 | DERIVATIVES

The major differences between futures and forward contracts are listed in Table 4.1.

Table 4.1: Comparison between futures and forwards

Futures Forwards

Clearing house is counterparty to each party to Private contract (‘over-the-counter’ or OTC)

the contract

Standardised contract—only the price is variable Tailored contract—all terms and conditions are
negotiable

Clearing house credit risk (normally negligible and Counterparty credit risk
limited to a single day)

Daily mark-to-market and settlement with Settled at maturity, so potentially large exposures
clearing house

Contract price centrally negotiated—e.g. by open Price by negotiation between parties

outcry on the futures exchange floor

Regulated through Futures Exchange Self-regulating but with government supervision

High liquidity enhanced by standardisation, Lower liquidity, but contracts readily neutralised by
centralised exchange and margining taking offsetting contracts

Close out by offsetting or reversing trade Close out by negotiation (or effectively by taking
opposite position in market)

Closed out prior to delivery in over 95% of cases Delivery/settlement usually takes place

Limited (standardised) number of settlement dates Any date possible for specifying settlement
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Forwards and futures can both be used for hedging, speculation and arbitrage. Positions can
be changed as frequently as desired, although hedges tend to be adjusted only when there is a
change in the underlying exposure that the hedge is covering.

Swaps
Swaps are the exchange or swapping of one obligation for another. They are by far the most
common derivative in use. Swaps are found in virtually every interest rate, foreign exchange,
commodity and securities market in operation, using every financial instrument available.

Using swaps, cash flows can be switched at will, obligations altered, and hedging, speculation
and arbitrage activities undertaken.

There is a wide range of swaps available, but they all operate in a similar fashion. This module
will concentrate on interest rate swaps. Foreign exchange swaps will be covered in Module 6.
 Study guide | 245

Economic equivalence
If any two series of cash flows are accumulated and/or discounted using the same discount
factors and to the same date, and if the values at that date are equal, the two series of cash flows
are said to be economically equivalent or of equivalent value. Economic equivalence represents
the imputed time value of money and is an important concept that is explained in more
detail below.

The relevance of economic equivalence

Tables 4.2 and 4.3 present a series of cash flows. In Table 4.2, the flows appear to be quite
different and to bear no resemblance to each other. This table shows nominal (or historical)
cash flows, which do not take into account the time value of money. For example, in the second
column under the heading ‘Single amount’, there is a figure of $14 443.38, representing cash in
hand (i.e. time t0). In the next column is an amount of $23 261.22, receivable in Year 5—time t5.
The remaining columns show nominal cash flows for a variety of scenarios, including both
receipts and payments and gaps in the timing of the cash flows.

Table 4.2 makes little sense until time is effectively neutralised by applying the time value of
money concept of net present value (NPV) and enabling each to be compared for their economic
equivalence. This is illustrated in Table 4.3.

Table 4.2: Equivalent sets of cash flows

Negative
Single Single Uniform Increasing Decreasing and positive Intermittent

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amount amount amounts amounts amounts amounts amounts
Year t $ $ $ $ $ $ $

0 14 443.38

1 3810.13 2000.00 5620.00 (2000.00) 4000.00

2 3810.13 3000.00 4620.00 (1000.00)

3 3810.13 4000.00 3620.00 6297.86 6946.13

4 3810.13 5000.00 2620.00 9000.00

5 23 261.22 3810.12 6000.00 1621.56 10 000.00 9000.00

Table 4.3 uses what is termed a discount factor from year 1 to year 5. This discount factor is
shown in the second column and is based on current interest rates (in this case 10%). It enables
all cash flows to be brought back to a common base, which in this case is today, or year 0.

For each set, the present value of each year’s cash flow can be calculated. These values are
totalled to obtain the present value of the set (as shown in the bottom row).

Note that it is now clear that the NPV of each of these cash flows is the same—that is, $14 443.38.
Since each set has the same present value, the sets are shown to be economically equivalent for
the given set of discount factors.
 246 | DERIVATIVES

Table 4.3: Present value at time t0 of cash flows in Table 4.2

Negative
and
Discount Single Single Uniform Increasing Decreasing positive Intermittent
Year factor amount amount amounts amounts amounts amounts amounts
t DF0, t $ $ $ $ $ $ $

0 1.000 000 14 443.38 0.00 0.00 0.00 0.00 0.00

1 0.909 091 3 463.75 1 818.18 5 109.09 (1 818.18) 3 636.36

2 0.826 446 3 148.87 2 479.34 3 818.18 (826.45) 0.00

3 0.751 315 2 862.61 3 005.26 2 719.76 4 731.68 5 218.73

4 0.683 013 2 602.37 3 415.07 1 789.49 6 147.12 0.00

5 0.620 921 14 443.38 2 365.78 3 725.53 1 006.86 6 209.21 5 588.29

Present value=V0 14 443.38 14 443.38 14 443.38 14 443.38 14 443.38 14 443.38 14 443.38

The implications of this economic equivalence can be profound.

Consider that a bank is indifferent to receiving a payment of $14 443.38 today or receiving
$23 261.22 in five years. As far as the bank is concerned, the amounts have the same value
(leaving aside the risk of non-payment in five years—that is an issue that the bank addresses
separately). The bank could advertise that if you pay your mortgage off today you would save
$8817.84 (i.e. $23 261.22 – $14 443.38). In purely nominal terms this is correct (‘Save over $8000
and five years of your mortgage’) but the claim fails to allow for economic equivalence.
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Even more significant is the fact that an organisation could take any one of the above seven
(or hundreds more) alternatives to the bank. In theory, the bank should be indifferent to the
alternative chosen. Organisations can therefore match borrowings with receipts, currency inflows
with outflows, and through the use of swaps radically reduce apparent cash mismatches.

An example provided in the next section illustrates the use of interest rate swaps to harness the
power of economic equivalence to reduce interest rate risk.

Interest rate swaps

An interest rate swap (IRS) is an agreement between two parties to exchange cash on a
notional principal sum that is not exchanged. The most common structure is the fixed-for-
floating swap in which one party (say, a company) agrees to pay a fixed rate over the term of
the swap in exchange for a floating-rate payment payable by the other party (say, a bank).
Virtually any combination of timings is possible and swaps can be constructed to suit a
company’s specific requirements.

The terminology used for a fixed-for-floating swap is that an organisation wishing to protect
against interest rates rising would agree to pay a fixed rate, while an organisation that wishes to
protect against falling rates would receive a fixed rate on an interest rate swap. The other side of
the swap is the relevant floating rate, which in Australia is usually the bank bill swap rate (BBSW)
for the period.
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Swap pricing and the nature of a swap: A string of forwards

The price that a financial institution will quote for a swap is based on the current yield curve.
A fixed rate for a period is the average price of the interest rates for the current and implied
forward periods, adjusted for the time value of money. The present values of the fixed flows for
a swap are calculated using the relevant interest rates for the period.

The interest rate used is a zero coupon rate. A zero coupon rate is an interest rate that has only
two cash flows—one at the beginning and one at the end of the time horizon. The zero coupon
rate is deemed the most appropriate for computing the present value of the cash flows, as the
concept of present value is that a future cash flow is converted back into today’s dollars and there
are no interim flows. Banks price and revalue products such as foreign exchange forwards, swaps,
options and forward exchange contracts using zero coupon interest rates.

Settlement calculation
Generally, with an interest rate swap the interest differential is calculated and then paid in arrears.
This means that a simple interest calculation is used.

Example 4.6
An organisation has a quarterly floating- (variable-) rate loan based on BBSW of AUD 10 million. To fix
the rate at 6.5 per cent, the organisation could either cancel the loan and take out a new fixed-rate
loan (an expensive undertaking), or simply execute an IRS where it exchanges floating-rate obligations
to pay for fixed-rate obligations.

In the September quarter the interest differential owing on the swap would be calculated as follows.

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Assume the IRS day count for the period between the June and September period is 92 days.
Assume that the BBSW three-month rate in June is 5.75 per cent.

June
The difference between the swap rate (6.5%) and the BBSW rate (5.75%) is 0.75 per cent.

The notional amount is AUD 10 000 000.

AUD 10 000 000 × 0.0075 × 92 / 365 = AUD 18 904.11 is owed by the organisation to the bank.
The difference of AUD 18 904.11, calculated in June, is paid by the organisation to the bank.

Trading process
The process for entering into an IRS is similar to entering into any financial arrangement, such as
a foreign exchange forward. The organisation contacts a financial institution and requests a
preference to switch from fixed to floating rates, or vice versa, for a stated period. The bank
quotes the rate and the contract is agreed. This all takes place over the phone and is considered
a legal contract once all details are agreed to between the parties.

No deposit is required, but the bank would need to have a credit limit in place for the organisation
before any transactions can take place. Each quarter, or relevant period, the interest differential is
calculated and then paid on the next calculation date.

Modules 5 and 6 continue this theme in greater detail by explaining the strategies involved
in using various derivative products to manage financial risk. Module 5 looks at interest rate
risk and discusses interest rate risk management, including choices between remaining
floating or converting to a fixed-rate exposure. It will explain the interest rate derivative
products such as swaps, caps and floors. Module 6 looks at foreign exchange and commodity
exposure management.
 248 | DERIVATIVES

Options
An option contract gives the buyer the right but not the obligation to buy or sell an asset at an
agreed price at or before an agreed future date. The underlying asset in an option contract can
be a physical commodity, a financial asset or some other measurable variable.

Options written on physical commodities such as metals, oil, natural gas and agricultural
products are called commodity options. Options on commodities can be used to manage
commodity price risk arising from selling or buying commodities.

Options on interest rate swaps, also known as a swaption, may be used to manage interest
rate risk in certain circumstances.

Options on interest rates can be used to manage interest rate risk arising from floating-rate
interest exposure, or future borrowing and lending programs.

Options on foreign exchange can be used to manage foreign exchange risk arising from foreign
currency transactions.

The option buyer pays the option seller a premium for the option. If the buyer exercises the
option at or before the agreed future date, the option seller is obliged to sell or buy the asset at
the agreed price (the strike price). If the buyer does not exercise the option by the agreed future
date, the option contract expires and is worthless. Option contracts can be over‑the-counter
(OTC) or exchange-traded (ET) contracts.

There are four basic types of options, which are outlined in Table 4.4, then illustrated in Figure 4.5.
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Table 4.4: Option matrix

Party Calls Premiums Puts

Buyer The right but not the obligation to Paid The right but not the obligation to
buy a commodity or instrument at a sell a commodity or instrument at a
predetermined price predetermined price

Seller The obligation but not the right to Received The obligation but not the right to
sell a commodity or instrument at a buy a commodity or instrument at a
predetermined price predetermined price
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Figure 4.5: Pay-off profiles of puts and calls (excluding premiums)

Note: P = Price of the underlying commodity or instrument

V = Value of the option excluding the premium

Pay-off diagrams are a means of illustrating the relationship between movements in the price of the
underlying commodity or instrument and changes in the value of the option.

These are shown ‘at expiry’—that is, on the final day of the contract. The exercise or strike price is placed at
the intersection of the two axes. This is illustrated below. In the top left-hand diagram, in the case of a buyer
of a call (also termed ‘long a call’), if the market price of the underlying commodity or instrument is less than
the option’s strike price, it would be foolish to exercise the option to buy at the higher price specified in the
option contract. Hence, the option will be allowed to expire; it has zero value. However, if the market price
exceeds the option’s strike or exercise price, the option has value—as illustrated in the diagram. The right to
buy the underlying commodity or instrument (long the call­) will be exercised.

∆V ∆V

∆P ∆P

(a) Buy a call (b) Sell a call

∆V ∆V

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∆P ∆P

(c) Buy a put (d) Sell a put

The pay-off profiles above assume that there are no underlying exposures, such as an interest
rate exposure caused by purchasing an Australian government bond or other fixed-interest
investment. The following example incorporates such an exposure.

In Figure 4.6 the change in value (V) and the related price associated with the first underlying
exposure to the change in interest rates (i) are detailed in the left-most diagram (labelled
‘Underlying exposure’). This is essentially the level of exposure to (i). The addition of an option
is shown in the second diagram, where the company has bought a call option on interest rates to
benefit from a rise in rates.

The right-hand pay-off diagram shows the result of combining the initial exposure and the call
option position, and hence diagrammatically represents the company’s net position. The gain on
the option offsets the fall in value resulting from the underlying exposure. This protects the value
of the underlying assets/exposure (in this instance the value of the fixed interest instrument/
government bond) if interest rates rise beyond the exercise price of the option.
 250 | DERIVATIVES

Figure 4.6: Underlying bond price exposures plus options—final trade-off profiles
(excluding premiums)

∆V ∆V ∆V

∆i ∆i ∆i

Underlying exposure Buy a call on i Resulting exposure

An example of combining a bought call option with an underlying exposure is shown in

Example 6.7, ‘Hedging with a bought Australian dollar call option’, in Module 6. The ‘Bought
AUD/USD 0.9200 call’ diagram shows that the underlying exposure of the exporter has revenue
declining as the AUD increases and revenue increasing as the AUD declines. The pay-off of
the bought AUD call increases as the AUD increases beyond the strike price. When the pay-off
profiles for the underlying exposure and the bought call option are combined, the net pay-off
profile of the resulting exposure shows that revenue for the exporter will still increase as the AUD
declines, but the pay-off from the underlying exposure and the bought call offset each other as
the AUD increases.

Option pricing
An option’s premium (price) has two main components, intrinsic value and time value.
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Intrinsic value is only relevant for ‘in-the-money’ options. It represents the difference between the
forward price of the underlying asset and the option’s exercise price, or strike price. A call option
is in-the-money when the forward price is higher than the strike price. A put option is in‑the-
money when the forward price is less than the strike price. At expiry of the option, there is no
time value remaining and so any value remaining in the option must reflect its intrinsic value.

Time value is the remaining premium in excess of intrinsic value before expiration. This amount
reflects the likelihood (probability) that the option’s value increases before expiration due to a
favourable move in the underlying security’s price. For an out-of-the-money option, there is no
intrinsic value and so the option premium solely reflects the option’s time value.

The key determinants in the price of basic or ‘vanilla’ options are outlined below.

1. Spot price
The movement in the underlying spot price (interest rate, commodity or currency) has the ability
to impact significantly on the value of the option. As the spot rate increases, the value of a
bought call option increases and the value of a bought put decreases. For example, if the spot
gold price increased from USD 1500 to USD 2000 per ounce and the strike price of a call option is
USD 1800, the value of the call option would increase.
 Study guide | 251

2. Strike price
Options values are sensitive to the point at which the strike price for an option is set. In the case
of a call option, if the strike price is set above the forward price, the option is said to be out of
the money and has no intrinsic value. Conversely, if the strike price is set below the forward
price, the option is in the money and has intrinsic value.

For example, if the current AUD/USD three-month forward rate is 0.7000, a three-month
Australian dollar call (US dollar put) option with a strike price of 0.7500 would have a lower
premium than the same option with a strike price of 0.6500.

3. Time to expiry
The amount of time until an option expires is an important consideration in determining an option
premium. All other things equal, the price of European-type currency options decreases at an
accelerating rate as the expiration date approaches. The longer the amount of time available for
the underlying spot price to vary, the greater the time value and therefore the higher the option
premium (see ‘Exercise type’ in ‘Other option terminology’ section later in this module).

4. Volatility
The effect of volatility can significantly affect the time value portion of an option’s premium.
Volatility is a measure of risk (uncertainty), or variability of price of an option’s underlying security
or currency. Higher implied volatility estimates indicate greater expected fluctuations (in either
direction) in underlying price levels and therefore increased probability that the option may
be exercised (i.e. being in-the-money) at maturity. As such, this expectation generally results in
higher option premiums for both puts and calls. During the GFC there was extreme uncertainty

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in markets, which resulted in increased premiums for options.

There are two types of volatility: historical (actual) volatility and implied (future) volatility,
which refers to the degree of price volatility that a particular currency is expected to show in
the future. It is the implied volatility that is used in determining an option price.

5. Domestic and foreign interest rates

Buying a call option enables the holder to postpone the decision to purchase a commodity
or currency or lock in an interest rate. Thus, the holder avoids the costs associated with such
a purchase (e.g. interest on borrowings), but the holder also sacrifices the benefits from being
exposed to that product (e.g. no dividends receivable). Interest rates may also be a determinant
of the forward price (e.g. for foreign exchange). The key determinants are summarised in
Table 4.5.

Table 4.5: Key determinants and drivers of option values

Increase in variable Call option value Put option value

Spot rate Increases Decreases

Strike price Decreases Increases

Volatility Increases Increases

Time to expiration Increases Increases

Interest rates Increases Decreases

 252 | DERIVATIVES

A variety of option pricing models, such as Black–Scholes and Cox–Rubinstein, have been
developed to determine option pricing. Another commonly used model for currency option
valuation is the Garmen–Kohlhagen model. In practice, sophisticated option pricing models are
used to calculate option valuations.

➤➤Question 4.2
What are the key factors that would influence the value of a bought Australian dollar call option?

Other option terminology

Further terms that you should be familiar with in discussing the use of options are outlined below.

Underlying asset
The asset that the option buyer can buy or sell at the agreed price is called the underlying asset.

Agreed price (strike price)

The agreed price is the price that the option buyer pays or receives for the asset. The agreed
price is typically called the strike price or exercise price.

Exercise
The exercise of the option involves the option buyer buying or selling the asset at the agreed
(strike or exercise) price.

Maturity date
The maturity date is the date by which the option buyer must either exercise the option or allow
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it to expire. The maturity date is also called the expiration date.

Time to maturity
The time to maturity is the period of time before the option expires.

Exercise type
There are two basic exercise types—European and American. European-type options can only
be exercised at the maturity or expiration date, while American-type options can be exercised at
any time during the life of the option.

Option buyer
The option buyer purchases the option contract.

Option seller
The option seller or writer is the short position in the option contract (e.g. sells insurance).

Option premium
The option buyer pays the option premium to the option seller for granting the right but not the
obligation to buy or sell the underlying asset. The option premium represents the market price
of the option. Option pricing models, such as the Black–Scholes–Merton model, can be used to
determine the fair price of the option.
 Study guide | 253

Settlement
Options can be settled by cash or by physical delivery. Some options are settled by cash only,
because physical delivery is impossible (where the underlying asset is not a physical asset) or
prohibitively costly (where the underlying asset is a basket of commodities). The option parties can
negotiate the method of settlement for OTC options. On the other hand, the futures exchange
sets the settlement terms for ET options.

Credit risk
Credit risk is the risk that the counterparty fails to meet its financial obligations. For example,
a lender is subject to credit risk because the borrower can default on its obligations. Credit risk
is present in all derivative transactions, including option transactions. In option contracts,
the option buyer has paid a premium for the option and therefore assumes the non-performance
risk of the option seller.

➤➤Question 4.3
What is likely to happen to foreign exchange option premiums if there is a major decline
in international tensions? Why?

Hedging using options

Companies can adjust their underlying exposures by using options to limit downside risk while
still allowing the company to benefit from favourable price movements.

Exposure management: Gold producer

MODULE 4
A producer has costs per ounce of gold of USD 760 and requires a profit margin of at least
USD 80. At the current gold spot price of USD 850 it is possible to buy a put option at an
exercise (strike) price of USD 850 for USD 10. This effectively means that the worst revenue net
of insurance premiums (i.e. the long put) would be USD 840, giving a margin of USD 80 per ounce
or better. This is illustrated in Table 4.6, which shows the possible outcomes at maturity once the
producer has already bought a put option for $10.

If, at maturity, the spot gold price is $790 (Column A), the producer would exercise the put for
$850 (Column B). The premium already paid was $10 (Column C). The producer would receive
$60 from the counterparty to the long put (i.e. $850 – $790) (Column E). The producer’s net
receipt is $840 (i.e. $790 + $60 – $10) (Column F).

Note that the only column that really interests the producer is the final column: ‘What’s in it for
me?’. The option is only a means to this end and has to be analysed in the context of the overall
exposure and required risk–return trade-off.
 254 | DERIVATIVES

Table 4.6: Hedging a producer’s gold exposure

A B C D E F G

Spot gold Exercise Premium Exercise Receipts Net Margin,

price at price on option? from long receipts given costs
maturity long put put after of USD 760
hedging per ounce

(B – A) if (A + C + E)
strike price
(B) exceeds
spot price
(A)

790 850 –10 Yes 60 840 80

800 850 –10 Yes 50 840 80

810 850 –10 Yes 40 840 80

820 850 –10 Yes 30 840 80

830 850 –10 Yes 20 840 80

840 850 –10 Yes 10 840 80

850 850 –10 No nil 840 80

860 850 –10 No nil 850 90

870 850 –10 No nil 860 100

880 850 –10 No nil 870 110

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890 850 –10 No nil 880 120

900 850 –10 No nil 890 130

910 850 –10 No nil 900 140

Note: All figures are in USD.

Figure 4.7 illustrates the outcome of adjusting the underlying exposure by purchasing (going long)
a gold put. In effect the end result resembles a long call, in that a premium or cost is paid in
order to benefit from increases in gold prices while limiting or flooring the effect of declines in
gold prices.

At the cost of USD 10 per ounce, the lowest gold price that the producer will receive, net of this
premium, is USD 840 per ounce, while the upside is potentially unlimited.
 Study guide | 255

Figure 4.7: Hedging with options

Using options
40
30
20
Pay-off/profit

10 Underlying exposure

0 Long put
–10 Final position
–20
–30
–40
810 820 830 840 850 860 870 880 890
Spot gold price at maturity

Determinants of option premium

Black–Scholes–Merton option pricing model
The fair option premium can be computed using an option pricing model. However, detailed
discussion of these models is beyond the scope of this module. The most popular option-pricing
model is the Black–Scholes–Merton2 model, in which five factors determine the fair option
premium. These are the:
• spot price of the underlying asset;
• exercise price;
• time to maturity;

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• risk-free rate of return; and
• expected volatility of the underlying asset.

The following table shows the difference between a hedging strategy using forwards and a
hedging strategy using options.

Table 4.7: Comparison between options and forwards

Bought options Forwards

The right but not the obligation to buy (call) or sell The right and the obligation to buy or sell
(put) a commodity, currency etc.

A premium is payable up front No up-front premium

Cash flows are dependent on whether the option Cash flows known at the start
is exercised

For an option buyer, the maximum loss is the Returns are fixed and risk of variation is eliminated
premium

Gains are potentially unlimited Returns are fixed and risk of variation is eliminated

As with insurance, downside risk is transferred from Returns are fixed and risk of variation is eliminated
the buyer of the option to the seller

Useful for uncertain cash flows Risky for uncertain cash flows

2
More information on pricing models is available at: http://www.asx.com.au/prices/pricing_models.htm
and http://www.asx.com.au/education/options-courses.htm.
 256 | DERIVATIVES

➤➤Question 4.4
For a gold-mining company exporting gold, what is the difference between a forward exchange
contract and a purchased USD put (= AUD call) option in respect of their impact on the company’s
forecast exposure to exchange rates?

Uses in hedging
Options can be used singly or in combination to provide solutions tailored to individual
requirements. Five examples follow, all of which could theoretically also be replicated
in commercial contracts.

1. Protection from further falls

Solution: Floor
Rather than using the terminology of traders, such as go long a put or short a call, risk managers
should use terminology that assists the business units to understand the objectives of the risk
management strategy. Where revenues are at risk, ‘floors’ are appropriate and where costs are
an issue, ‘ceilings’ should be discussed.

In the present case it is assumed that there is some level of currency, commodity or interest
rate return below which the company does not want to risk falling—in which case an option is
purchased to ensure a floor is put into place.

2. A company requires ‘crisis’ protection only

Solution: Out-of-the-money option
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In the case of extreme movements in foreign exchange or commodity prices, there may be levels
at which the company would suffer serious consequences. An option that is only able to be
triggered at a value a considerable distance from the current price level is much less expensive
than an option at or near to ‘the money’.

3. Even cheaper ‘crisis’ protection only

Solution: Knock out
To reduce the price even further, companies could consider having the option terminated
should prices move in the opposite direction beyond a specified level. An example of this was
the Australian Wheat Board’s crisis protection against a weak US dollar (as the wheat is sold in
US dollars), which was knocked out if the US dollar strengthened by more than 10 per cent as the
board could then sell its US dollars forward at a rate that ensured targeted profit margins were
either achieved or exceeded.

4. Benefit from falls

Solution: Reverse floater
This is a situation where, instead of protecting against falls in a financial price, the organisation
wants to benefit from the fall. A reverse floater (otherwise called an ‘Inverse floater’) means that
the rate or return paid to the holder increases as floating rates decline.

5. Benefit from further rises

Solution: Leveraged floater
This strategy might be used where interest rates are expected to rise and, rather than increase
its investments, the company takes a security that has a coupon providing it with increasing
(or leveraged) income. This occurred after the GFC when interest rates were so low that the
probability of rate rises was very high.
 Study guide | 257

The bottom line is that there is a possible range of solutions that may involve a preferred
trade‑off of risk against return to an outright forward or futures contract.

Further, there may be factors other than simple risk–return trade-offs that could influence the
use of risk management products. These could include:
1. Tax. This can be a major influence on the products used, particularly as derivatives such as
swaps can change cash flows to any financial year from any financial year—and do the same
with currencies and commodities.
2. Transaction costs. A good example is foreign exchange, where a bank’s forward prices use
interbank interest rates as the basis of pricing—so it is highly unlikely that a company would
be able to achieve as efficient a result by trying to replicate the forward price through using
its own borrowing and investing ability.
3. Agency costs. These refer to the costs of using intermediaries and are perhaps well
illustrated with reference to some of the massive salaries paid by financial intermediaries
which are derived from client fees.
4. Reporting. Accounting for derivatives can be costly and may also result in misunderstandings
at board and shareholder levels. These issues are discussed in Module 7.

Exotic derivatives and hybrids

Tailored or exotic options
These options are more complex than options that trade on an exchange, and provide specific
solutions to corporate risks. Some of the more common types of tailored or exotic options are
listed in Table 4.8.

MODULE 4
Table 4.8: Examples of exotic (also called ‘tailored’) options

Technical name Characteristics Use by companies

Knock-out An option that ceases to exist if a Can provide less expensive protection to
pre‑determined price level is reached. companies by giving insurance against
unfavourable price movements which is
knocked out on following a favourable
price move.

Knock-in An option that doesn’t exist until a Like many exotic instruments introduced
pre‑determined price level is reached. by financial institutions, the practical use
of a knock-in eludes the author.

Compound An option on an option. There are four This type of option can be useful when
main types of compound option: a call on tendering, providing the tenderer
a call, a put on a put, a call on a put and with protection against adverse price
a put on a call. Compound options have movements at a cheaper price than the
two strike prices and two exercise dates. underlying, non‑compound option.

Source: J. C. Hull 2009, Options, Futures and Other Derivatives, 7th edn,
Prentice Hall, Upper Saddle River, New Jersey.
 258 | DERIVATIVES

Derivatives on other assets

This section includes a description of a selection of derivatives out of a large range of specialised
or exotic derivatives. The objective is to provide an insight into potential advantages as well
as threats of exposure to these markets. The instruments selected are credit, weather and
energy derivatives.

Credit derivatives
Credit risk is faced by a lender and is the risk that a borrower defaults on their obligation to repay
principal and interest. Until the early 1990s organisations had only a limited ability to hedge
against this risk, but major developments in the securitisation of portfolios allowed organisations
to use credit ratings, as the basis of a major expansion in the underwriting of credit derivatives
and, therefore, of the development of a deep secondary market.

The major form of credit derivative is the credit default swap (CDS). A CDS facilitates the transfer
of credit risk from the risk protection buyer to the risk protection seller. The reference asset is
typically a bond issued by the reference entity. The protection buyer, the protection seller and the
reference entity are, typically, unrelated parties.

The seller of the credit default swap guarantees the credit worthiness of the end product,
while the buyer of a CDS receives credit protection. By doing this, the risk of default is transferred
from the holder of the security to the seller. The protection buyer gains the right to sell reference
assets at par or face value to the protection seller should a credit event occur. The protection
buyer pays the protection seller a spread or premium on a periodical basis for this right.
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Initially, the CDS was a spectacular success. Between 2000 and 2007, the market in the US for
such swaps ballooned from USD 900 billion to more than USD 30 trillion—in a market that was
virtually unregulated with minimal or inadequate controls on pricing and credit standards.

Ultimately, this rate of growth was unsustainable and contributed to its breakdown, a fact
that was eventually recognised in mid-2007 when major US investment banks rapidly quit the
market and caused one bank, Bear Stearns, to default. This was the first major failure, but others
followed, culminating in September 2008 when, in a single weekend, the largest insurance
company in the US failed, Bank of America was taken over and Lehman Brothers was liquidated—
triggering the GFC.

As CDS volumes declined, hedging of credit risk became virtually unattainable, and the damage
triggered by this market failure spread throughout the globe.

Energy and other derivatives

Energy derivatives are instruments whose underlying asset is based on energy products such
as oil, natural gas or electricity, available as exchange-traded (ET) products as well as over-the-
counter (OTC) contracts. Energy derivatives can be in the form of options, futures, forwards or
swaps. As with all other derivatives, an energy derivative’s value will vary with the price of the
underlying product.

In Australia the exchange-traded energy markets comprise futures and options over Australian
electricity, New Zealand electricity, thermal coal and natural gas, and, following the probable
introduction of carbon taxes, futures and options contracts over Renewable Energy Certificates
(RECs) and Certified Emission Reductions (CERs). All these markets are relatively thinly traded.
 Study guide | 259

Electricity derivatives
The Australian National Electricity Market (NEM) is the world’s largest interconnected power
grid that includes all states and territories in Australia, except Western Australia and the
Northern Territory, with over AUD 10 billion traded annually. The ‘pool’ is a market-clearing set of
regulations operated by the Australian Energy Market Operator (AEMO), which adjusts spot prices
in various sub-sectors every five minutes with published half-hourly spot electricity prices which
vary from a floor of minus AUD 1000/Megawatt hour to a cap of plus AUD 12 500/Megawatt hour.
Generators sell and retailers buy into the pool at AEMO’s spot rate. Suppliers vary in their ability
to increase supply, from one minute for hydro to two days for some coal‑fired generators.

The spot price also provides the base price against which futures and options prices are settled.
Daily trade in futures and options in 2011 was around AUD 20 billion—a small fraction of the size
of foreign exchange and interest rate markets, which globally are in the trillions.

The majority of trading is based on swaps (fixing electricity prices against the floating benchmark).
The most popular traded options are caps—ensuring a maximum cost of electricity—and average
rate options, which are based on the average electricity price over a pre-specified period.

A very small amount of trade is done in more specialised derivatives, as shown in these
three examples.

1. Callable and putable forwards. For a purchaser, a callable forward comprises a combination
of a long (bought) forward contract and a short (sold) call option. An example of their use is in
an interruptible supply contract. The electricity supplier may sell a callable forward, enabling
it to exercise the (bought) call option whenever the spot price exceeds the strike price,
effectively cancelling the (sold) forward contract at the time of delivery.

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A putable forward is a combination of a long (bought) forward contract and a long (bought)
put option. An example of its use is in a dispatchable power producer supply contract.
The customer (purchaser of the putable forward) may exercise the put option whenever
the spot price falls below the strike price, effectively cancelling the forward contract at the
time of delivery.

2. Swing options. These allow power to be used when it is relatively cheap. The buyer has the
right to adjust delivery amounts at short notice in order to reduce peak usage and to exploit
troughs in prices. They are also known as flexible nomination options, because the buyer
has the ability to have numerous changes on a predetermined scale and/or over a specified
period (for example, a month).

3. Tolling agreement. This is where the buyer buys the right to operate and control
the scheduling of the plant for a tolling fee.

Carbon market and derivatives

According to the World Bank, globally there are 39 national jurisdictions and 23 sub-national
jurisdictions that have implemented or are scheduled to implement carbon-pricing instruments,
including emissions trading systems and taxes (World Bank 2014). Carbon pricing is seen as
one of the key mechanisms of reducing greenhouse gas emissions as it uses market signals to
put a cost on the practice of emitting greenhouse gases, and creates an economic incentive
to reduce emissions.
 260 | DERIVATIVES

Emissions trading schemes (ETS) work by placing a cap on the amount of emissions that a
company can emit. Permits are issued to companies allowing them to emit a certain amount of
emissions. If a company needs additional emissions permits they would need to buy them in the
market from a company that requires fewer permits. So companies are charged for polluting,
while others are rewarded for emitting fewer emissions.

Weather derivatives
Weather derivatives are potentially useful for a wide range of groups, such as farmers, concert
promoters, electricity producers or users and tourist operators. Weather derivatives are unusual
in that the underlying ‘asset’—rain, no rain, heat or cold—has no direct price to enable the
derivative to be valued. Additionally, weather is specific to individual areas, so there is no real
ability to arbitrage the markets or in many cases even to theoretically price the derivative.

Following is an example of how things can go wrong in specialised derivatives. In the US,
Chubb Inc. first sold drought derivatives. The company allowed derivatives to be purchased
right up to the week before the ‘payout’, so it sold virtually no derivatives up to the week
before the closing of the product then, in the last week, with no rain, actual or forecast, it sold
USD 350 million worth of extremely cheap cover. It was financially disastrous for the company
and extremely beneficial for drought-affected farmers.

Weather derivatives started trading in the US in 1996 and the Chicago Mercantile Exchange
(CME) introduced the first weather futures options in 1999. Contracts include options on rainfall,
hurricanes and tornadoes, plus the most common form of all contracts, Heating Degree Day
(HDD) or Cooling Degree Day (CDD) contracts. These are based on the cumulated difference in
daily temperatures relative to the 18°C level over a fixed period, such as a month, and across a
MODULE 4

range of US, European and Australian cities, including Brisbane, Sydney and Melbourne.

In Australia, insurance contracts cover some weather risks, such as floods and storms,
with weather derivatives effectively non-tradeable on exchanges and risk cover only available
through reinsurance at this stage.

Managing the counterparty component of

credit risk and operational risk
The underestimation of credit risks is now accepted as a key factor in triggering the global
financial crisis and the overleveraging of markets due to excessive debt creation. Therefore,
considerable effort has been expended in identifying credit risk arising in derivatives markets,
especially counterparty risk—the risk of counterparty default—and operational risk—essentially
fraudulent behaviour by employees.

Counterparty risk—estimations using credit value adjustments

One way of managing counterparty risk is to estimate the combination of the actual risk of
default and then to adjust by the potential loss given a default.

Credit Value Adjustment (CVA) is a market estimate of the measurement of counterparty credit
risk and can be defined as the difference between the risk-free and risky value of a transaction,
which is equivalent to the expected loss arising from a counterparty default.
 Study guide | 261

The standard formula is:

CVA = Discounted expected exposure × Default probability × Loss, given default

A derivative’s value is adjusted by this credit value adjustment, or CVA, to provide a credit
risk‑adjusted value. Interestingly, the CVA on some instruments, especially swaps, can be positive
or negative depending on which of the two counterparties is more likely to default and the
expected amounts receivable and/or payable to each party.

Risks vary depending on the depth of the market (greater depth reducing risk), the influence
of covariance within portfolios, time to maturity and implied volatility. Because of covariance,
the CVA of a portfolio will virtually always be lower than the sum of individual CVAs.

Following the GFC, it is becoming increasingly common to quote a CVA price rather than a
risk‑unadjusted price. The aim is to adjust the value of the derivative so that every instrument has
the same risk-adjusted return on capital—that is, the return on a portfolio of credit derivatives is
expected to be the same as a portfolio of currency swaps or interest rate options. The derivatives
are risk-adjusted and then the appropriate capital is allocated so that return on the capital
is uniform.

More and more banks now factor the CVA into their quoted prices to corporates and other
bank counterparties rather than having a portfolio or ‘flat price’ approach to their products.
Overall, the aim of the seller of a derivative is to get the same return on capital across the credit
spectrum; thus the derivative must be valued then capital allocated against the potential cost
of default. The inclusion of CVA in derivative pricing by banks can significantly increase the
cost for companies using derivatives to hedge.

MODULE 4
It should be specifically noted that the above refers to over-the-counter derivatives only. Exchange-
traded derivatives are not subject to counterparty credit risk as one function or characteristic
of these instruments is that the Exchange guarantees the settlement of the derivative contract,
thus removing counterparty credit risk.

Since the early 2000s, the international accounting authorities IASB and FASB determinations on
Offsetting Financial Assets and Financial Liabilities have also required that as credit adjustments
are made, so too should debit adjustments in order to correctly determine fair value.

Such valuations of both debit and credit risk have resulted in surprising outcomes—
as the following example from 2009 illustrates. Citigroup, following the collapse of Lehman
Brothers and the GFC, benefitted counter-intuitively from its downgrading. As reported by the
financial press in October 2009:
(Citi) have to mark their liabilities to fair value, and in the case of their own debt (or in this case
liabilities on derivative positions), they have to consider their own default potential as a component
of fair value. So the more likely it becomes that Citi will default on their debt/swaps, the less those
instruments are worth to the investors that hold them. Therefore the accounting guidance says that
Citi should reduce the value of the liabilities on their books, and they book this reduction as a gain
through the income statement. As an auditor I find the guidance to be ridiculous, but it is the rule
so companies are following it … (so) Citigroup … took a $1.7 billion credit value adjustment and
boosted their profits (Fox 2009).
 262 | DERIVATIVES

Centralised clearing
Following the GFC of 2008, there was virtual consensus amongst national and international
regulators that some centralisation of the clearing and settlement stages of derivative trading
(i.e. once a transaction was agreed), continuous supervision and control was vital for ongoing
market stability and user confidence in the system. The Group of 20 (G–20) have therefore set
as a goal that all standardised over-the-counter derivative contracts should be traded either on
physical exchanges or approved computer-based systems cleared through central counterparties
(CCPs) by 2013. The aim is to facilitate multilateral netting and, in so doing, reduce overall
volumes of residual counterparty risk. This change is relatively straightforward for interest rate
swaps and forward rate agreements, but much harder and more expensive for currency swaps
(multiple countries of settlement) and for credit default swaps.

The rules regarding the mandatory use of CCPs for Australian derivatives are still being finalised.
In July 2014, Treasury released its proposals paper for mandatory clearing of Australian dollar
derivatives based on recommendations put forward by APRA, ASIC and the Reserve Bank of
Australia, in consultation with key market participants. The current proposals limit the mandatory
clearing of Australian dollar derivatives to large internationally active banks only.

Operational risk governance

Under the Bank of International Settlements Basel regulations covering risk measures,
operational risk is defined as the risk of loss resulting from inadequate or failed internal
processes, people and systems, or from external events. This is covered in greater depth in
Module 8 ‘Controlling risks’.
MODULE 4
 Study guide | 263

Review
The objective of the module was to introduce the concept of derivative instruments, which are
financial instruments that ‘derive’ their value from underlying financial instruments, commodities
or benchmarks.

The four main classes of derivatives were examined—forwards, futures, swaps and options.
The fundamentals of pricing the key derivatives were then outlined.

These instruments are able to be combined with basic financial products such as spot prices for
currencies and commodities and bonds, bills of exchange and other core financial instruments
to provide hybrids such as weather, energy and credit derivatives. However, the key principle
is that all pricing is based on the standard tools surrounding the concept of net present value
and the interlinking of markets. These basic concepts of derivatives will be applied in later
modules (particularly the modules related to interest rate risk management and foreign exchange
and commodities), to both strategic and operational aspects of financial risk management by
non‑financial institutions.

MODULE 4
MODULE 4
 Suggested answers | 265

Suggested answers
Suggested answers

Question 4.1
Disagree. Forward AUD/USD rates are a function of the difference between the prevailing
AUD/USD interest rates. Expectations of future AUD/USD rate movements have no bearing on
the forward rates.

MODULE 4
Question 4.2
The key factors are spot price, strike price, time to expiry, interest rates and volatility. Option price
makers on banks’ trading desks use these factors as an input to option pricing models.

Question 4.3
They are likely to decline. A major factor in option prices is the expected volatility of the
exchange rate. A reduction in the volatility input to a vanilla option pricing model will always
result in a lower price.

Question 4.4
The forward exchange contract will fix the AUD revenues to the gold producer. The revenue on
the hedged sales will not vary with changes in the exchange rate.

The option will put a floor under the revenues and lock in a worst-case result. The gold producer
will benefit from changes to exchange rates under the option strike rate.
MODULE 4
 References | 267

References
References

Buffet, W. E. 2003, Berkshire Hathaway Inc. 2002 Annual Report, Berkshire Hathaway, Omaha, NE.

Fox J. 2009, ‘Strange things in the BofA and Citi earnings statements’, Time Business,
16 October, p. 3.

Hull, J. C. 2009, Options, Futures and Other Derivatives, 7th edn, Prentice Hall, Upper Saddle

MODULE 4
River, New Jersey.

Reserve Bank of Australia 2014, ‘Glossary’, accessed August 2014, http:www.rba.gov.au/glossary/

index.html.

World Bank 2014, State and Trends in Carbon Pricing 2014, World Bank, Washington DC, May,
accessed October 2014, www.worldbank.org.

Optional reading
A large number of websites available can provide excellent tutorials, including those of the
Chicago Board Options Exchange (CBOE), ASX and the Singapore International Monetary
Exchange (SIMEX).

Mun, J. 2005, Real Options Analysis: Tools and Techniques for Valuing Strategic Investments and
Decisions, 2nd edn, Wiley, New York.
MODULE 4
 FINANCIAL RISK MANAGEMENT

Module 5
INTEREST RATE RISK MANAGEMENT
RICHARD ALLAN
 270 | INTEREST RATE RISK MANAGEMENT

Contents
Preview 271
Introduction
Objectives
Background 273
Why interest rates are important
Drivers of interest rates
Nominal and real rates, pre- and post-tax
Yield curve and the term structure of interest rates
Key steps in interest rate risk management 280
Step 1: Set the core criteria
Step 2: Identify exposures and sensitivities
Sensitivities
The management of timing mismatches
Risk management through offsets
Step 3: Appraise risks and set strategies
Debt and investments
Timeframe for interest rate risk management
Determination of the fixed/floating ratio
Revision of hedge policy
Step 4: Manage risks (treasury operations)
Interest rate risk management instruments—overview
The key IRRM financial instruments—swaps and options
Step 5: Accounting and controls
Review 315

Appendix 317
Appendix 5.1 317

Suggested answers 323

References 329
Optional reading
MODULE 5
 Study guide | 271

Module 5:
Interest rate risk
management
Study guide

Preview
Introduction
Interest rates represent the price for money. They link spot and forward markets, and they are the
key to facilitating national and global cash flows over time and currencies.

MODULE 5
The aim of any organisation’s risk management activities is to identify, create, enhance and
protect stakeholder value by managing volatility and the uncertainties that could either positively
or negatively affect the attainment of that organisation’s objectives.

This module examines interest rate risk from the perspective of a financial markets end-user,
rather than that of a financial institution. The module specifically builds on Module 1 ‘Introduction
to enterprise risk management’ and Module 4 ‘Derivatives’.

Interest rate risk is the exposure of an organisation to movements in interest rates, which
affect cash flows and profitability of the organisation. Changes in interest rates also affect the
underlying value of the firm’s assets, liabilities and derivative instruments because the present
value of future cash flows changes when interest rates change.

Interest rate risk management (IRRM), both strategic and operational, is a core skill of a corporate
risk manager. IRRM is the process of identifying, quantifying and managing the interest rate risk
that an organisation faces. It involves identifying the types of interest rate exposure within the
organisation, measuring the impact of interest rate risk on earnings and considering means to
mitigate or hedge the risk.
 272 | INTEREST RATE RISK MANAGEMENT

It is possible to mitigate and manage the effects of interest rate risk by using derivative
instruments to hedge interest rate exposure. As is apparent from Figure 5.1, interest rate
derivatives—swaps and options—are much more prevalent than foreign exchange derivatives
(swaps, forwards and options), and other derivatives, such as commodity swaps.

Figure 5.1: Australian banks’ derivatives positions*

Notional principal amounts outstanding

$
15
Other
Interest rate
FX
12

0
1990 1995 2000 2005 2010

* Includes both OTC and exchange-traded derivatives for locally incorporated banks and foreign banks’
branches, not adjusted for double counting

Source: Based on data from Reserve Bank of Australia 2012,

‘OTC derivatives market reform considerations’, RBA, March, Canberra.

IRRM enables organisations to take advantage of opportunities and to control or eliminate

potentially adverse movements in costs and returns that may affect obligations such as borrowing
covenants or the potential risks of default on debt servicing. If done well, IRRM can enhance
MODULE 5

borrowing capacity and in the case of investments, protect the portfolio’s value. IRRM is therefore
designed to both protect against adverse movements and to protect returns and the value of
the organisation.

Objectives
At the end of this module you should be able to:
• explain what interest rate risk is;
• identify the sources of interest rate risk;
• evaluate the implications of interest rate risk management on cash flow;
• determine the key drivers that impact on interest rate risk management; and
• evaluate the effectiveness and appropriateness of techniques to manage interest rate risk.
 Study guide | 273

Background
Why interest rates are important
Overnight inter-bank borrowing rates (official cash rates) are controlled by central banks and,
as a result, movements in these and other short-term interest rates are less volatile than prices
for other financial instruments. The exception is where the government loses control of rates and
prices and hyperinflation causes interest rates to become virtually unmanageable. For example,
in the former Yugoslavia between 1 October 1993 and 24 January 1995, prices increased by
five quadrillion per cent. That’s a five with 15 zeroes after it.

E N
C IM
SPE

Nominal interest rates were in excess of 1000 per cent a day. The paper on which the note was
reproduced became more valuable than the note itself. A more recent example is in Zimbabwe,
where in mid-November 2008 inflation peaked at an annual rate of 89.7 sextillion per cent
(89 700 000 000 000 000 000 000%). The peak monthly rate was 79.6 billion per cent, which is
equivalent to a 98 per cent daily rate. At that rate, prices were doubling every 24.7 hours
(Hanke & Kwok 2009).

E N
C IM
SPE

MODULE 5
In the post-2008 era of world financial uncertainty and unrest within financial markets,
the concerns for structural stability such as the breakdown of the eurozone has put great
pressures on some countries and their interest rate regimens. For example, at the start of 2012,
the official euro short-term government rate was 1 per cent while in Greece, the borrowing
rate by governments (reflecting lenders’ inflation expectations and their view on the likelihood
that the debt will be repaid) was in excess of 150 per cent—while, domestically, Greek citizens
could still borrow from the main six domestic banks at under 5 per cent.

Such a situation is untenable beyond a few months, when either political or economic macro
factors drive the economy either to an austerity program or to recession and (if outside a currency
bloc) to major currency devaluations with highly volatile interest rate markets.
 274 | INTEREST RATE RISK MANAGEMENT

Drivers of interest rates

This leads into the issue of how interest rates are set and how prices are determined. In Australia,
the Reserve Bank (RBA) has overall responsibility for monetary policy and for the stability of the
currency. In practice, this has meant that, by and large, the RBA has allowed the Australian dollar
to find its own level but has exerted far greater control over interest rates. Until 2012 Australian
banks followed the RBA’s movements in the official cash rate in adjusting their own rates, so,
compared with the exchange rate, interest rate movements have been less volatile and certainly
more predictable than exchange rates.

Internationally, central banks have exerted similar influences on interest rates, allowing exchange
rates to be the ‘white noise’ or the balancing item in world price mechanisms. This goes a long
way towards explaining why exchange rates are so hard to forecast, as they are relative prices and
they pick up relative movements in random changes.

Figure 5.2 shows the official policy rates of the G3—an IMF-initiated term that designates the
economic grouping of the world’s top three developed economies: the US, the Euro Area and
Japan. The G3 is crucial in influencing world economic growth and these three rates are the
benchmark against which all other rates—including Australia’s—are measured.

Each of the G3 key rates was less than 1 per cent in nominal terms since the euro crises of 2011.
Through 2013 rates have been so low that, since March 2013, Japan has switched from rate
targets to a quantity target—the rate of growth of the money supply, not its price.

Figure 5.2: Policy rates: G3 (US, Euro Area and Japan)

Policy interest rates—G3

% %
US

5 5
Euro Area

4 4
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3 3

2 2

1 1
Japan

0 0

–1 –1
2005 2007 2009 2011 2013

* Since April 2013, the Bank of Japan’s main operating target has been the money base.

Source: RBA 2013a, ‘RBA chart pack—Updated regularly for financial markets and other statistics’,
accessed August 2013, http://rba.gov.au/chart-pack/interest-rates.html.
 Study guide | 275

The implication is that there is virtually no way to stimulate economic growth by further lowering
official rates. Effectively, these G3 policy—or official government—interest rates have been
driven down to the floor, meaning the G3 has to seek the other two main routes to stimulating
the economy: exchange rates (with the ever-present danger of exacerbating the ‘currency
wars’ referred to in Module 1) and monetary quantity stimuli, such as the US Federal Reserve’s
‘quantitative easing’—essentially the printing of money to stimulate economic growth. These low
nominal rates are reflected in commercial rates, but with very substantial credit loadings and
potentially with an increasingly volatile relationship between real and nominal rates.

It is therefore now appropriate to address the distinction between nominal interest rates and real
interest rates.

Nominal and real rates, pre- and post-tax

The nominal interest rate is the stated interest rate. For example, if a financial institution pays
5 per cent annually on a savings account, 5 per cent is the nominal interest rate.

The real interest rate is the nominal rate of interest minus inflation, which can be expressed
approximately by the following formula:

Real interest rate = Nominal interest rate – Inflation rate

The effect of taxation also needs to be noted.

Most interest earned, or any positive return from investments, is taxed. However, taxes apply to
the nominal rate of return, not the real rate:

Real rate of return = Nominal interest rate × (1 – Company tax rate) – Inflation rate

Example 5.1: Calculating the real interest rate after tax

If an organisation earned 5 per cent nominal interest on its money with 3 per cent inflation, and the
corporate tax rate is 30 per cent, what is the real interest rate after taxes?

MODULE 5
Solution
Using the above formula:

Real rate of return = 5% × (1 – 0.30) – 3% = 0.50%

Yield curve and the term structure of interest rates

The yield curve plots interest rates for various maturities at a particular point in time and is often
referred to as the term structure of interest rates. There are three typical yield curve shapes as
shown in Figure 5.3. They are (a) normal yield curve, (b) inverse yield curve and (c) flat yield curve.
 276 | INTEREST RATE RISK MANAGEMENT

Figure 5.3: Yield curves

Yield
12

10
Normal

8
Inverse
6

Flat
4

0
1 day 180 days 1 year 1.5 years 2 years 2.5 years 3 years 3.5 years 4 years 4.5 years 5 years 10 years
Time

An interest rate forward curve is the implied yield curve of interest rates applicable at a future
point in time. The calculation of an implied forward interest rate requires the knowledge of the
current market interest rate applicable from today until the beginning of the future borrowing
period, and the current market interest rate applicable from today until the end of the future
borrowing period.

The yield curve beyond the official cash rate reflects the market’s expectation about the level
of future interest rates. The various rates along the curve are mathematically related and any
differences will be arbitraged by traders.

An important interest rate–related curve is the swap curve, which traces the prevailing swap rates
as quoted in the market, typically from one to 10 years.

The swap curve is derived from three market instruments. It commences with the cash rate,
MODULE 5

which reflects the overnight rate applicable in the market. Next are the bank-accepted bill (BAB)
rates, which range from 30 to 270 days. Finally, there are the swap rates, which range from one to
10 years.

For issuers of financial instruments, other curves can be created that reflect the underlying interest
rates (i.e. the risk-free rates plus the credit margin relating to the issuer). Larger organisations can
issue their own debt with differing maturities, which allows for a yield curve to be constructed for
that entity. As the credit standing of companies is not as strong as the government, the yield for a
particular time to maturity is higher. This gives the investor a higher return to compensate for the
higher risk being taken.

Figures 5.4 and 5.5 show how the four main interest rates in Australia have moved between 2000
and 2013, and Figure 5.6 shows how the 10-year treasury bond rates and 90-day bank bill rates
have moved between 2000 and 2013.
 Study guide | 277

Figure 5.4: One-year and 10-year AUD interest rate swap rates

9.0

8.0

7.0

6.0
Percentage points

5.0
1 year
4.0 10 year

3.0

2.0

1.0

0.0
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

Source: Based on data from RBA 2013b, ‘Statistical tables’, accessed July 2013,
http://www.rba.gov.au/statistics/tables/index.html#content.

Figure 5.5: RBA cash and 90-day BAB* rates

9.0

8.0

7.0

6.0
Percentage points

MODULE 5
5.0
90 day Bills
4.0 RBA Cash

3.0

2.0

1.0

0.0
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

* BAB = Bank-Accepted Bill

Source: Based on data from RBA 2013b, ‘Statistical tables’, accessed July 2013,
http://www.rba.gov.au/statistics/tables/index.html#content.
 278 | INTEREST RATE RISK MANAGEMENT

Figure 5.6: 10-year treasury bond rates and 90-day bank bill rates

9.0

8.0

7.0

6.0
Percentage points

5.0
10 year Govt Bond
4.0 90 day Bills

3.0

2.0

1.0

0.0
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

Source: Based on data from RBA 2013b, ‘Statistical tables’, accessed July 2013,
http://www.rba.gov.au/statistics/tables/index.html#content.

The other major issue with IRRM is the need to allow for the difference between the value of
cash flows over different time horizons. This involves discounting and uses the net present value
concept introduced in Module 3. The following case study illustrates the concept.

Case Study 5.1: Analysing interest rate expenditures

To: Head of Procurements

Department of Housing
MODULE 5

Canberra
From: Secretary
Department of Housing
Subject: Parliamentary Housing: Financials

I note that you have agreed to pay $28 000 000 in five years’ time for the proposed Parliamentary
Accommodation Suites.

However, my advisers point out that if we pay for it immediately it would cost only $19 743 982.

Please explain this extraordinary wastage of $8 256 018.

Sincerely,
Richard Ponting
Secretary—Department of Housing

Note that interest rates from years 1–5 are:

• Year 1: 6.600 per cent
• Year 2: 6.800 per cent
• Year 3: 7.001 per cent
• Year 4: 7.100 per cent
• Year 5: 7.200 per cent
 Study guide | 279

Which of the following explanations is the most acceptable?

(a) Both viewpoints relate to the same real value so it is irrelevant as to what option is selected.
(b) Richard Ponting’s point is quite legitimate and the contract should be renegotiated so that payment
takes place immediately.
(c) While it will cost more to pay later, no payment can be made until the buildings have been
satisfactorily completed.
(d) Paying later costs no more in real terms and may have substantial practical as well as
political benefits.

To: Secretary
Department of Housing
Canberra
From: Head of Procurements
Subject: Parliamentary Housing: Financials

The requested explanation is provided below.

Reconciliation 1
If payments are deferred until year 5, the cash payment would be $28 000 000, which has a present
value of $19 743 982.

Reconciliation 2
Alternatively, five equal instalments could be made over the next five years and would result in cash
flows totalling $24 107 548. The present value of this scenario is also $19 743 982.

Sincerely,
Christopher Wren
Procurements

Net present value (NPV) calculations

Zero Discount PV of Swap
Payments coupon rate factor payments rate Difference
0 0
1 0 6.600% 0.938086 0 6.600%

MODULE 5
2 0 6.807% 0.876598 0 6.800%
3 0 7.020% 0.815840 0 7.001%
4 0 7.126% 0.759312 0 7.100%
5 28 000 000 7.237% 0.705142 19 743 982 7.200%
28 000 000 19 743 982 8 256 018

0 0
1 4 821 509 6.600% 0.938086 4 522 991 6.600%
2 4 821 509 6.807% 0.876598 4 226 527 6.800%
3 4 821 510 7.020% 0.815840 3 933 582 7.001%
4 4 821 510 7.126% 0.759312 3 661 032 7.100%
5 4 821 510 7.237% 0.705142 3 399 850 7.200%
24 107 548 19 743 982 4 363 566

Note: Calculations are provided for illustrative purposes only. Candidates are not required to be
able to perform these calculations.

The first half of the table shows the amount of $28 000 000 payable in year 5 discounted to an equivalent
of $19 743 982 in year 0 (today). While this results in an apparent difference of $8 256 018, this figure
is meaningless because it confuses present with future value.

The second half of the table discounts five equal yearly payments back to their equivalent value today,
which in this case is $19 743 982—the same as for the single bullet payment of $28 million in year 5.
 280 | INTEREST RATE RISK MANAGEMENT

In theory, a purchaser should be indifferent to paying these five instalments, paying $28 million in
year 5 or $19 743 982 immediately.

Accordingly, the most acceptable explanation for the financial disagreement over parliamentary
housing is explanation (d).

Explanation (a) is incorrect because, although the values are identical in real (or present/future value)
terms, other factors have an impact on what option is selected. For example, as the actual (nominal)
cash flows are different and have different timings, we would need to consider access to funding,
credit risk and cash flow management.

Explanation (b) is incorrect because the nominal values cannot be compared directly if there are
timing differences.

Explanation (c) is incorrect because it seems to concede that deferral will involve a larger amount
being paid—which is not correct when real values are compared.

Explanation (d) is correct with respect to the values being identical in real rather than nominal terms,
and takes into account other practical and political issues.

Further to explanation (c), deferral of payment until the building is complete makes considerable
sense, especially if it involves no trade-off in the form of increased real costs. However, there may be
even more factors to be considered. For example, this approach may be attractive to a government
wishing to defer expenditure until after an election.

Case Study 5.1 illustrates that NPV issues alone may not provide a conclusive answer and, in both
the private and public sectors, ignoring some of the non-NPV factors may result in incorrect
decisions being made.

Key steps in interest rate risk management

These steps were discussed in Module 1 in relation to the overall financial risk management
process and are reproduced below.
MODULE 5

The process of effective interest rate risk management (IRRM) involves five key steps:
• Step 1: Set the core criteria.
• Step 2: Identify exposures and sensitivities.
• Step 3: Appraise risk and set strategies.
• Step 4: Manage risks (treasury operations).
• Step 5: Account and controls.

Each step is explained in detail in the remaining sections of the module. Note that dealing and
financial products (e.g. swaps, forward rate agreements) are highly visible parts of IRRM, but they
really only occur in step 4 of the process.

Figure 5.7 is based on Module 1 (Figure 1.18) and has been adapted specifically for IRRM.
 Study guide | 281

Figure 5.7: Specific financial risk management process

1. Set the core criteria

Stakeholder Functional Business/Industry Key strategic

expectations currency drivers objectives

Apparent exposures

2. Identify exposures and sensitivities

Embedded Internal Timing Commercial

Offsets
options (Intra-company) mismatches adjustments

(Goal setting) Risk-adjusted exposures

3. Appraise risks and set strategies

Probabilities/
Tolerances Benchmarks Contingencies Insurance
Consequences

4. Manage risks
(treasury operations)

Proactive Ongoing Reactive

• Windows of opportunity • Liquidity management • Hedging
• Contract management • Working capital management • Financial engineering
• Facilities management • Project management

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5. Accounting and controls

Step 1: Set the core criteria

The first step is to identify the ‘big picture’—that is, to clarify the underlying risks and put them in
the context of the organisation’s key strategies and benchmarks.

Goals are then set by the board of directors, with the goals reflecting the directors’ views as to
the degree to which returns should be tempered by management of risk.

Performance measures or benchmarks are then put in place to bias behaviour towards the
achievement of these goals—leaving the tactics (the ‘how to’ of exposure management) largely
to treasury and the business units.
 282 | INTEREST RATE RISK MANAGEMENT

Step 2: Identify exposures and sensitivities

A significant issue for an organisation is determining the sensitivities of its operations to price
and rate fluctuations—commodity, currency and cash. In most cases, the relationship between
movements in its products’ prices and movements of the financial market is erratic, with variable
time lags and intra-industry and inter-industry linkages further confusing the picture. Cash flow or
funding estimates are subject to frequent and often substantial revisions and are a combination
of information from the profit centres and from head office and of capital and operationally
related receipts and expenditures. Clearly, good communication and recording systems are the
first essential ingredients in getting—and keeping—on top of exposure management.

The process can be described through the flow diagram in Figure 5.8.

Figure 5.8: Identify risks

Apparent exposures

Embedded options?

Yes No

Can they be embedded?

Yes No

Repricing clauses?
Ceiling/floor arrangements?
CPI adjustments?
On-costing etc.?
Guarantees?

Funding offsets?

Yes No
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Currency loans?
Timing offsets?

Exposure grid

Interest
+/– Sensitivities
Critical rate
Volatility
Risk category
 Study guide | 283

Sensitivities
Once the initial exposure—such as the revenue from a stream of sales—is identified, determine
next whether it is worth managing the exposure at all. That is, is the exposure significant enough
to warrant intervention?

The pay-off diagram

Exposure sensitivities can be mapped onto a pay-off (or profit and loss) diagram. For a borrower,
the profile would be similar to that shown in Figure 5.9.

Figure 5.9: Pay-off profile: Return-based

Costs/Returns

Targeted returns

Interest 4 5 6 7 9 10 11 12
rates
% p.a. Current floating
Minimum acceptable return

Enlarging the above diagram shows the ‘minimum acceptable’ and ‘targeted return’ interest
rates. This merely lines up different interest rate/revenue flow combinations with various trigger
points—such as the borrowing costs (5%), which would allow targeted returns to be achieved;
and the borrowing cost (10%), which represents the highest level of costs that could be sustained
if the underlying product/business is to remain marginally profitable.

Another way of demonstrating exactly the same information is shown in Figure 5.10.

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Figure 5.10: Pay-off profile: Cost-based

Costs/Returns

$100 000
(Maximum sustainable cost) $90 000
$80 000
Interest 4 5 6 7 9 10 11 12
rates
% p.a.
$60 000
$50 000
$40 000 (Target cost)

In this case the pay-off diagram has graphed direct borrowing costs rather than the underlying
returns associated with these costs. This approach is equally acceptable—it largely depends on
which is preferred by management, a focus on returns or a focus on costs.
 284 | INTEREST RATE RISK MANAGEMENT

The management of timing mismatches

This section examines the balance sheet and methods of adjusting interest rate risk.

A simplified balance sheet can help develop techniques for identifying and managing cash flows
and the possible effects of mismatches in these flows.

Once this has been created, further risk management can be undertaken by identifying the timing
of the renegotiation of the pricing of interest rate–sensitive assets and liabilities (called gapping
analysis), and any timing mismatches can then be reduced or eliminated by adjusting payment
schedules or through the use of swaps.

A statement of financial position is effectively a snapshot of a company’s profile at a particular

point in time. However, from the viewpoint of a treasurer, each of the assets and liabilities can
also be seen as a set of cash flows—each of which is potentially capable of being adjusted.
Table 5.1 lists some of the methods of adjusting the embedded cash flows.

Table 5.1: Adjusting timings of cash flows: Balance sheet items

Examples Primary techniques Financial instruments and tools

Cash Electronic funds transfer, netting accounts,

sweep facilities, direct debiting

Inventory Re-order procedures

Subcontracting

Debtors Credit terms Trade finance, factoring,

• Domestic Restructuring forfeiting, securitisation
• International Factoring/forfeiting

Investments Portfolio management Swaps, derivatives (e.g. forward

Intercompany swaps rate agreements (FRAs))
Restructuring

Motor vehicles Leasing (sale and leaseback) Insurance (options)

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Plant and equipment Project financing Insurance (options)

Rental, sale and leaseback

Creditors Rescheduling Refinancing

Borrowings Restructuring, derivatives adjusting Options, swaps

facilities

Capital Issues Calls, warrants

Reserves Revaluation

Some examples of cash flow management are as follows.

• Cash. The use of electronic funds transfer can considerably improve cash flows. Other
techniques, such as automatically ‘sweeping’ the sub-accounts of subsidiaries into a central
account at head office, can also improve cash management.

• Inventory. Stock and inventory control procedures are often a business unit responsibility,
but because they are a major influence on working capital requirements, treasury’s role is
often to encourage the increased efficiency of inventory management. Post-Christmas sales
can be looked at as the traditional method of inventory liquidation.
 Study guide | 285

• Debtors. These can be sold (factored or forfeited, to use the technical terms), or even
securitised—that is, effectively capitalised via some sort of borrowing vehicle/instrument.
Credit terms are often a critical factor in debtor management, as the cost of carrying debtors
via increased working capital costs and doubtful debts and management costs can be a
pivotal factor in treasury management.

• Borrowings. The mix of debt of fixed-rate facilities, floating-rate exposures and even the
currencies involved is one of treasury’s core operations. Take, for example, the debt matrix
shown in Table 5.2.

Table 5.2: Debt matrixes

Short term Long term

Fixed Local Local
currency currency
(LCY) FX (LCY) FX
Floating Local Local
currency currency
(LCY) FX (LCY) FX

Case Study 5.2: GFC Ltd

Consider a medium-sized company with the following statement of financial position.

GFC Ltd statement of financial position

Assets Liabilities and equity

$(000)s $(000)s
Deposits* 16 000 Overdraft* 5 000
Stock 40 000 Bank bills* 35 000
Fixed assets 144 000 Creditors 10 000
Term debt 30 000

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Equity 120 000

200 000 200 000

* Interest rate sensitive.

Maturity profile: Timing of reinvestment/repricing

0–3 3–6 6–9 9–12 Over 1 year Total

Rate sensitive assets $1m $3m $3m $2m $7m $16m

Rate sensitive $5m $7m $3m $25m $0m $40m

liabilities

Gap (A–L) –$4m –$4m $0m –$23m $7m –$24m

In the maturity profile above, the $16 million of rate-sensitive assets and $40 million of rate-sensitive
liabilities (see the statement of financial position above) are arranged according to their re-pricing. For
example, in the 0–3 month period, $1 million of rate-sensitive assets mature and have to be re-invested,
while $5 million of liabilities come up for renegotiation.

Overall, there is a net position of –$4 million in the 0–3 month timeframe. This is known as a negative
gap. A negative gap arises where the value of interest-rate sensitive liabilities maturing in a given time
period exceeds the value of interest-rate sensitive assets maturing in that same time period.
 286 | INTEREST RATE RISK MANAGEMENT

If more assets than liabilities mature in a period, as in the more than one-year period of +$7 million,
there is a positive gap. A positive gap arises where the value of interest-rate sensitive assets maturing
in a given time period exceeds the value of interest-rate sensitive liabilities maturing in that same time
period.

With a normal yield curve, the interest rates for short-term maturities are relatively lower than for long-
term maturities. A normal yield curve would benefit GFC Ltd where it wanted to borrow short-term at
low rates (i.e. negative gap under one year) and invest longer term at higher rates (i.e. positive gap
over one year).

With an inverse yield curve, the interest rates for short-term maturities are relatively higher than for
long-term maturities. An inverse yield curve would benefit GFC Ltd where it wanted to invest short-
term at high rates (i.e. positive gap under one year) and borrow longer term at lower rates (i.e. negative
gap over one year).

The overall position is shown in the table below.

Implications

Rates decrease Rates increase

Negative gap Gain Lose

Positive gap Lose Gain

GFC Ltd will benefit from: Under 1 year 1 year and above
(a) Normal yield curve Negative gap Positive gap
(b) Inverse yield curve Positive gap Negative gap

Risk management through offsets

There are two types of offsets—primary and secondary.

Primary offsets:
• commercial offsets;
• foreign currency offsets;
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• commodity offsets;
• embedded options;
• price adjustment clauses; and
• diversification (portfolio).

Secondary offsets:
• financial restructuring.

Primary offsets are outlined in more detail below.

Commercial offsets
Intra-industry practice may significantly affect the actual extent of an organisation’s exposure to
variations in interest rates. The classic example is the trading banks, which tend to all increase or
decrease their rates in line with government moves in official rates. This protects their margins—
and for most financial institutions it is the margins rather than outright levels of rates that
determine profitability. However, it is also the case with many organisations, where movement
in rates triggers general industry price movements, such as commercial rentals. In many cases,
rent on retail sites is indexed to CPI or retail sales (both of which have a relationship to interest
rates). Organisations with such exposures will consider the impact of interest rate movements on
their rental expense or revenue when determining their exposure to interest rates.
 Study guide | 287

Many organisations need to also examine the profitability of their business during the overall
business cycle. Where a relationship exists between interest rates and business profitability,
an organisation should consider both the direct and indirect effects of interest rate changes on
its business.

As an example, consider an organisation specialising in building residential homes which notices

that, as interest rates increase, the cost of housing increases and demand for the organisation’s
services will decrease. An increase in interest rates will therefore affect its business in two ways:
firstly through the increased cost of financing its business, and secondly through the dampening
effect on demand.

A more subtle example arises where the terms of trade with suppliers and customers contain
discounts that reflect the time value of money (discounts for early payments). As interest
rates change, these terms of trade should be reviewed to determine whether adjustments
are required.

Embedded options
There is always a need to look for any industry-based adjustments (automatic or otherwise)
to the organisation’s exposures. Three examples may help to illustrate this class of exposure
adjustments:

1. Ceiling/floor price arrangements. An agreement to accept only a pre-specified range

of interest rate movements, beyond which there is no further adjustment, also effectively
transfers risk/benefit to the other party. However, if there is not a genuine transfer (as in the
floor price schemes in Australian commodities such as the now defunct wool floor price,
where the growers fund the scheme itself), then the adjustment may only be postponed
rather than transferred.

2. CPI adjustments. Where prices or costs are adjusted for inflation, the exposure to domestic
rates is reduced as real interest rates are more stable than nominal interest rates.

3. On-costing. Some organisations are able to pass on to the other party charges in the cost
of producing their product. In this case, the exposure normally reduces only to the margin the

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organisation was making on the transaction—again, resulting in a transfer of risk.

In each of the above cases there may have been a trade-off negotiated to permit the adjustments
(or options) to be embedded. By comparing the costs of these trade-offs to the cost of doing
the same thing through the financial market—that is, actually buying/selling an option with
a bank—the organisation can accurately gauge whether or not the embedded option has
been fairly priced. The organisation can also calculate in advance just how much it can give up/
charge prior to any contract negotiations—a very useful tool in any marketing strategy.

You should now review Appendix 5.1 which discusses embedded options in relation to the
Bond Corporation.

Foreign currency offsets

Foreign currency exposures can be measured by allocating expected foreign currency cash flows
to time buckets (e.g. months). Offsets may be determined through the expected receipts and
payments in the foreign currency. For example, future expected cash flows may be presented
as shown in Table 5.3, which provides a basis for liquidity and funding management. In this
table, we can see that interest payment of USD 200 000 per month provides a small offset to
the monthly trade receipts.
 288 | INTEREST RATE RISK MANAGEMENT

Table 5.3: Currency exposure matrix

Forward month
Currency USD (000)

1 2 3 Total

Trading flows—receipts 2000 1500 2500 6000

Trading flows—payments (1000) – – (1000)

Interest paid (200) (200) (200) (600)

Interest received – – – –

Borrowings – – – –

Deposits 500 – – 500

Net exposure 1300 1300 2300 4900

Commodity offsets
Various inputs into an organisation’s product, or adjustments by way of semi-finished goods
or stock, may either enlarge or offset the apparent exposure to interest rates. For example,
if electricity is a major cost of production, but government authorities are precluded from
increasing tariffs by more than a pre-set ceiling, the organisation’s exposure to interest rate
movements is commensurately smaller, as electricity providers will not be able to pass on the
cost of any interest rate increases through electricity prices.

Price adjustment clauses

One of the most common but rarely correctly quantified offsets is the price adjustment clause,
by which the organisation is able to transfer its exposure to interest rate movements (or partial
interest rate movements in the case of CPI-based adjustments) to the other party. As these are
effectively options, they can be readily quantified by pricing them in the financial markets—
that is, by replicating them. Treasury functions can easily provide this service to business units,
but rarely do (and are even more rarely asked to do so). It is important to note the Module 7
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discussion that IAS 39 requires all embedded options to be identified and priced.

The effect of diversification—the portfolio of risks

The sum exposure of a group of business units (BUs) is rarely the same as the simple aggregate
of their individual exposures. This is because of offsetting factors between the two, the effect of
covariance. Portfolio theory states that this interaction dampens the volatility of group results,
reducing the need for each BU to individually allow for exposure management.

In practice, some of this dampening is deliberate (e.g. borrowing in the same currency as export
income is denominated) and others come from industry conventions (e.g. oil companies passing
on their price exposures to the consumers or end-users).

Table 5.4 provides a useful summary for the board of GFC Ltd of the company’s overall
exposures to financial risk. The three areas of exposure are compared, with sensitivities relating
to commodity price changes, interest rate movements and FX volatility. While FX exposures are
less than interest rate sensitivities, in fact they are seen as critical because estimated volatility
in currency markets (+/– 10 cents) means that it is likely that the 8 cent movement identified as
critical to the company is therefore expected to be triggered. On the other hand, commodity
price movement is evaluated as only ‘moderate’ due to the relative stability (+/– $2) of prices.
 Study guide | 289

Table 5.4: Financial risk matrix: Summary for board of GFC Ltd

Commodity price Interest rate Exchange rate

Exposure (assumed) $40m $300m $70m

Sensitivity (effect on profit of + $1.25m + $3m + $1.45m (@ .70)

a $1/1%/1¢ movement)

Price/rate change critical to 12 4 8¢

company

Estimated volatility $2.0 2.5% 10.0¢

Relative importance Moderately exposed Highly exposed Critically exposed

Note: For the purposes of this subject, it is not necessary for candidates to understand how the
data in Table 5.4 has been derived.

Table 5.4 is simplistic in the present model as it does not allow for two important factors:
• interactions between the three prices; and
• remedial or reinforcing action (depending on the direction of the change) by the organisation
to offset the changes in price—although this can be allowed for by adjusting the sensitivities.

These sensitivities are then put into context by calculating the movement required to breach a
target. Volatilities are added as a measure of probability of future movements (again in this case a
simplistic measure) to come to an overall assessment of the importance of each exposure to the
organisation in the coming year.

In most large organisations it is possible to calculate an overall risk–return position for any
period, based on the tripartite risk factors (and allowing for covariance). Figure 5.11 illustrates
an organisation’s risk–return profile.

Figure 5.11: Overall risk–return trade-off

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Return
40
30
20
10 x Current estimate

Risk
–10
Likely range of returns
–20
–30
–40

The overall implication for the above organisation is that while the expected return is around
10 per cent, the combination of price volatilities (commodity, exchange and interest rates) sees
that the confidence limits for the organisation are between +35 per cent and –15 per cent.
While the upside results look promising, the downside needs some degree of control. In other
words, the organisation needs to set some goals for exposure management.
 290 | INTEREST RATE RISK MANAGEMENT

Conclusion
In summary, there are three main steps for a manager to take in exposure identification:
1. Calculate raw exposures.
2. Determine primary (industry-based) immunisation:
–– offsets; and
–– adjustment clauses—that is, embedded options.
3. Examine secondary (financial market based) adjustments.

Steps 1 and 2 should be taken prior to the next major stage of exposure management—
goal setting. Step 3 can only be taken once the board/management has set its goals.

Step 3: Appraise risks and set strategies

Once the exposures to be managed have been measured and sensitivities calculated, the next
step is to determine the company’s strategy—both immediate and over the next few phases of
corporate growth. These goals need to be set at board level, for the decision is a highly strategic
one and the effect of correctly or incorrectly set goals will be felt throughout the organisation.
Two board decisions are necessary at this stage:
• the risk–return trade-off (and the degree of freedom to manage same) required with respect
to corporate and profit-centre positions; and
• the goals of the dealing unit if (and only if) treasury is to operate its dealing unit as a profit
centre, and therefore to take positions in the interest rate markets.

There are also three possible timeframes within which strategies should be set:
• immediate operational strategies—for example, up to 12 months;
• longer-term operational strategies—for example, a future devolution of dealing authorities; and
• structural strategies—that is, those relating to controls and combinations.

These strategies should be put into the context of the overall treasury operation, which is
outlined below.

Identifying benchmarks
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Benchmarks will depend on what each organisation, subsidiary or interest group elects to target.
Possible benchmarks include:
 Net income 
• return on assets (ROA)—a possible target for company boards  ROA = ;
Total assets 
• product margins—commonly used by operating units; and 
• bonus pools/retrenchment triggers—for staff-orientated negotiations or operations.

The procedure for translating the ‘raw’ sensitivities into meaningful targets is a simple one.
First, the outright sensitivities are graphed (or tabulated—whatever is required).

Figure 5.12: Sensitivity levels

$
Exposure $10m
borrowing

$100 000
Interest $200 000
rates
% 5 6 7 8 10 11 12 13
 Study guide | 291

In Figure 5.12, an exposure of $10 million (borrower) has been assumed. Thus, if interest rates fall
from 8 per cent to 7 per cent, the organisation will save $100 000. Is this significant?

The change of $100 000 needs to be put into the context of the organisation. If, for example,
the organisation targets ROA, what ROA is achieved if funding is fixed at the currently available
9 per cent?

Now various points on the vertical or Y axis are nominated as being relevant to the organisation’s
planning targets for the year.

• Budget rate. The minimum acceptable ROA consistent with overall group targets. This has
been set at 9.5 per cent, which implies an achievable interest rate of 11.5 per cent.

• Minimum return. The level below which returns must not fall; otherwise, trust deed covenants
may be triggered—in this case 8 per cent ROA, implying an interest rate of 13 per cent.

• Productivity bonus. Bonuses may be paid if a certain ROA is reached—in this case
15 per cent ROA or an interest rate of 6 per cent.

Figure 5.13 shows these trigger levels.

Figure 5.13: Trigger levels

ROA%

16
Productivity bonus
15
14
13
Interest
rates
% 5 6 7 8 11 10 11 12 13

Budget rate 10
9
Minimum return

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8

Clearly, a large number of possible targets can be set. However, once they have been selected,
they automatically highlight those interest rate levels that are critical to the organisation.

X axis versus Y axis

The essential difference between corporates and dealers is that corporates focus on the
objectives as defined on the vertical axis, and dealers concentrate on deciding their position
on future price movements as per the horizontal axis. While it is true that some corporates run
a dealing operation and take views on their future direction, they are either:
• a pure dealing/trading operation in their own right and a de facto financial institution; or
• taking a view on interest rates with respect to their underlying position.

Equally, while banks and other financial institutions have profit centres such as dealing rooms,
they are also companies and as such have shareholders’ positions to consider and currency
exposures to manage. At this level they should operate like any other company with interest
rate exposures.
 292 | INTEREST RATE RISK MANAGEMENT

Debt and investments

Following the global financial crisis (GFC), no organisation needs to be reminded that a crucial
area of liquidity risk lies in costs and returns associated with an organisation’s debts and
investments.

Before the GFC, most organisations tried to minimise the interest-bearing investments they held.
This strategy avoided the unnecessary inflation of balance sheets (which can negatively affect
financial ratios) and minimised the costs associated with the margin (or spread) between interest
paid on outstanding debt and interest received on investments. Interest-bearing investments
were minimised by using surplus funds to retire short-term debt and, where financially preferable,
arranging access to standby lines of finance rather than holding excess cash balances (where
‘cash’ is defined to include bank bills and similar instruments).

This strategy was severely tested in the period following the GFC as cash became king (earning a
significant premium) and cash reserves proved to be invaluable to many organisations—including
many not-for-profit organisations that hold reserves in lieu of equity. As a result, borrowers with
cash reserves were courted by the financial institutions and often enjoyed negative net spreads
between earnings and borrowings, which is not a normal phenomenon. The lesson to be learned
is that all conditions need to be considered when determining an overall debt and investment
policy and that no hard and fast rules exist.

Where companies do hold interest-bearing investments, they often match the term of the
investments with the term of their debt (e.g. if the debt is subject to a floating interest rate reset
every 90 days, they would match the interest rate on the investment to also reset every 90 days),
thereby reducing their exposure to interest rate movements.

Availability and margins

Another lesson of the GFC has been that while in theory funds may be available to borrow at
reasonable margins, other terms and conditions designed to protect the banks and other lenders
may make such borrowings extremely expensive or even prohibitive. For example, many banks
in Australia required standby facilities to be in place if clients were to be able to draw down
funds under their existing bank bill facilities. This meant that the previously agreed margins
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on the bills became inflated by the cost of the standby facilities and made many borrowings
uneconomic—a form of rationing credit, particularly to small and medium-sized businesses (SMEs).

Timeframe for interest rate risk management

When considering a company’s sensitivity to movements in interest rates, the question arises as
to the timeframe over which interest rates should be managed. For example, assuming that the
board of directors has resolved to hedge 60 per cent of interest rate risk by locking into fixed
interest rates (a big assumption), how far out should the rates be fixed?

Life of the assets

Some organisations consider that the timeframe for IRRM should reflect the life of the assets.
The rationale is that once the life of the asset has expired, the debt should have been repaid and
the cost of the debt can also be reset through establishing a new interest rate associated with
new debt to finance a new asset.

While there is some logic in this approach for shorter-term assets, it ignores the fact that for
long‑term assets (including plant and equipment), a high component of fixed interest rates may
prove expensive and even result in competitive disadvantages should there be subsequent
periods of low interest rates.
 Study guide | 293

Variability in cash flows

In a refinement to the life of the assets approach, some organisations analyse the flexibility of
the cash flows that the assets generate to determine an appropriate timeframe over which to
manage interest rate risk. This approach takes into consideration the ability of an organisation to
pass on high interest rates in the pricing of the goods and services it produces.

In other words, the interest rate hedging program cannot protect an organisation from the
economic cycle over an extended time. Sooner or later, the organisation must reprice its goods
and services, which in turn influences financing costs.

Consider the situation of interest rate risk in the electricity industry in Australia, the relevant
regulator determines part or all of the retail prices at regular intervals (in some cases five years).
Hence, the ability to pass on interest rate increases (or decreases) through electricity prices will
be limited to the regular review, and participants in the electricity industry are likely to focus their
interest rate hedging around those reviews.

Determination of the fixed/floating ratio

Having established the timeframe over which interest rate risk is to be managed, the organisation
also needs to determine the percentage of interest rate risk that will be fixed and the percentage
floating. This involves determining the degree of volatility the organisation is prepared to accept
in short-term interest rates during the current financial year, and ensuring that its long-term IRRM
activities are designed to limit the degree of short-term floating rate exposure. This risk–return
trade-off is one of the key issues to be resolved at board level.

The financial strength of the organisation

The financial strength of the organisation will have a large bearing on the degree of volatility it is
prepared to accept in its interest expense. Factors that organisations consider in this area include
the potential impact of short-term interest rate movements on:
• financial covenants with lenders (EBIT/interest paid being the most common);
• financial ratios monitored by rating agencies and financial analysts;
• the potential to meet or miss budget objectives; and

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• weighted average cost of capital (WACC) calculations used in determining regulated pricing
for utilities.

Scenario or some other form of sensitivity analysis enables organisations to estimate what
percentage of their interest rate risk needs to be fixed to ensure that the above factors are not
adversely affected.

Competitors’ hedging policies

Organisations should also be aware of their competitors’ IRRM policies. This awareness helps
to ensure that competitive advantages and disadvantages are not unwittingly created through
financing costs as a result of hedging over vastly different timeframes, using vastly different fixed/
floating ratios or taking a vastly different approach to hedging.

The board’s risk appetite

Ultimately, it is the board which will accept responsibility for the financing costs of the business.
Hence, it is the board that will decide the most appropriate trade-off between certainty
(fixed rates) and risk/opportunity (floating rates), and the timeframe over which interest rate
risk will be managed. The board’s appetite for risk (concerning the potential impact of interest
rate movements on reported earnings) will be reflected in the hedging limits set.
 294 | INTEREST RATE RISK MANAGEMENT

Revision of hedge policy

Having determined the timeframe for managing interest rate risk (say, five years) and an
appropriate fixed/floating ratio at the start of each financial year (say, 60% fixed), the question
remains as to whether the ratio should be 60 per cent fixed for each year of the five-year
timeframe or whether the ratio should change each year.

The impact of a fixed hedge ratio

There are two key problems associated with a fixed hedging ratio for each year of the
hedging period:
• the costs associated with normal or upward sloping yield curves; and
• repricing risk.

Upward sloping yield curves

At the beginning of each year, an organisation ceases recognising year 1 (which becomes
year 0 or the current financial year and therefore becomes subject to short-term IRRM) and
recognises the new year 4 (see Figure 5.14).

To hedge 60 per cent of year 4, the organisation is confronted with having to enter into a forward
start swap—that is, a one-year swap starting in four years’ time. A forward start swap obligates
the counterparties to enter into a swap that begins in the future, under the terms negotiated in
the present. In a normal yield curve environment, the cost of that swap will be at a rate higher
than the five-year swap rate. Therefore, knowledge of the forward curve is important for those
organisations that have a known long-term borrowing requirement.

Given that the swap curve reflects the market’s expectation of future interest rates, organisations
can make informed decisions as to the level of interest rate hedging they wish to undertake in
order to satisfy their individual risk appetites (which in turn may reflect borrowing covenants or
policy limits).

Assume that a company has $100 million of floating debt on issue. Its current hedging policy
requires it to hedge 60 per cent of its total exposure for four years (remembering that the
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current year is considered year zero). If the yield curve is upward-sloping (i.e. ‘normal’ yield curve),
as shown in Figure 5.14, the one-year swap rate beginning in four years’ time will be higher than
the five-year swap rate.

Figure 5.14: Normal yield curve

6.80
Interest rate %

7.00%
6.60

6.40

6.20
0 1 2 3 4 5 6
Term to maturity
 Study guide | 295

This pricing can be shown by the relationship between forward and spot rates:

(1 + r )
5

Forward rate4, 5 = 5
–1
(1 + r )
4
4

where:
the forward rate4,5 is the implied forward rate for one year in four years’ time
r5 is today’s (spot) five-year swap rate
r4 is today’s (spot) four-year swap rate.

If the five-year swap rate is 6.60 per cent and the four-year swap rate is 6.50 per cent as
in Figure 5.14, the implied forward rate used in pricing the one-year forward start swap is
7.00 per cent. In the case of a normal or upward-sloping yield curve as illustrated in Figure 5.14,
the cost of hedging the later periods is higher than the cost of hedging the entire period in
a normal yield curve environment. In these cases, borrowers often prefer to only hedge the
earlier periods—and in the case of an inverse curve, to hedge over a relatively longer period,
thereby lowering the average known cost.

Repricing risk is not sufficiently mitigated

The effect of fixing the interest rate in this fashion is that the impact of the prevailing interest rate
environment (either high or low interest rates) will not affect the organisation until a number of
years into the future. When the future year becomes the current year, the organisation will feel the
full impact of the interest rates having been set in a different interest rate environment. Example 5.2
in the next section demonstrates this.

Step 4: Manage risks (treasury operations)

As shown in Figure 5.7, the management of interest rate risk consists of three main areas.

1. Proactive management
Proactive management involves the identification of windows of opportunity so as to
permit organisations to benefit from movements in the cost of funds and/or the return

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on investments. The philosophy of ‘monitoring carefully’ is unacceptable.

Returning to the process first introduced in Figure 1.18 (‘Specific financial risk management
process’) in Module 1, once sensitivities to interest rates and other financial variables have
been quantified, triggers or key levels need to be set to ensure that action can be taken
swiftly when a potential but not necessarily predicted event occurs. This may include a trigger
to refinance when a window of opportunity occurs, rather than to ‘monitor carefully’ and
effectively do nothing.

See Figures 5.4 and 5.5 to see the relatively dramatic fall in rates over a short period of time.

2. Ongoing management
Liquidity and working capital management forms the basis of IRRM. Organisations rarely fail
due to a short period of unprofitable trading. Failure usually results from a shortage of cash
which can be instantly fatal if it involves the inability to service debt or meet the organisation’s
financial obligations when they fall due.

Equally, an organisation should not have its borrowing facilities up for renegotiation over a
narrow timeframe. In the event that rates rise quickly at that time, the organisation would
rollover a number of existing loans into higher-rate agreements, which could result in a
liquidity crisis. Negotiation of borrowing facilities should be spread over a six- to 12-month
period, and preferably be part of the medium- to long-term business plan.
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3. Reactive management
Reactive management relates to short- and long-term active management of identified
exposures to interest rate volatility. It may involve structural management, such as linking
the interest debt servicing to an underlying project, or more complex financial engineering
management such as interest rate collars which have a limited upside and downside.

However, for the purposes of this module, the focus is on standard financial risk management
instruments and their application.

Interest rate risk management instruments—overview

The instrument used will depend on the nature of the management issue. Once the sensitivities
have been quantified and the timeframe determined, the choice of financial instrument is largely
driven by the nature of the issue.

Example 5.2
The board of Conundrum Ltd is looking to decide on its overall interest rate risk strategy, particularly
in the light of its current concern that a financial crisis will cause rates to become highly volatile.
The board also wants to know which financial instruments would best achieve the desired strategy.

The board requested the CFO to summarise the alternatives for the company’s four-year debt,
currently with floating rate and priced with reference to the Bank Bill Swap Rate (BBSW).

The table below sets out the core alternatives.

Applications of IRRM—the financial instruments in context

Requirement Result Instrument/method Cost

1. Remain fully floating Unlimited upside None

cost, minimum cost
approaching 0%

2. Reduce exposure— Moderates effect of Swaps Depends on swaps

fixed/floating mix movements in rates curve
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3. Remove uncertainty— No benefit from Swaps Depends on swaps

fix costs favourable moves curve (cost if normal
Cash flows for debt curve, benefit if
servicing now known. inverse curve)

4. Protect target profit Potential upside Options

level benefits but known
maximum servicing
costs

5. Crisis protection— Cheaper than (4) Options

miss target level but
ensure no breach of
covenants
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Requirement Result Instrument/method Cost

6. Protect downside but Collar option

at zero premium outlay (zero cost option)
Combination of cap
and floor—premiums
cancel

7. Example of one of a Knock-out option

range of tailor-made
alternatives: Protect
minimum profit,
but cheaper than
Alternative (3)

Following is a summary of these alternatives, which will be looked at in more detail below.

1. Remain fully floating

This is still the most common form of borrowing in Australia and in most major economies.
When increased costs can be passed on—as is the case in Australia with respect to banks
and their mortgage books, as well as many other organisations—it effectively implies that the
company has no real exposure, but can pass it through to an intermediate or end-user.

2. Reduce exposure—fixed/floating mix

This is the fixed/floating rate decision covered in detail in Step 3: Appraise risk and set
strategies.

3. Remove uncertainty—fix costs (or investment income in the case of assets)

Cash flow requirements to service debt become fixed, but there is an opportunity foregone
should rates on borrowings fall below the locked-in rate—and with a positive yield curve,
the initial impact is a negative one in terms of debt servicing costs. This is due to the fixed
rate of the swap being higher than the current floating-rate borrowing. If the yield curve
was inverse, the fixed borrowing cost under the swap would be lower than the current
floating rate.

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4. Protect target profit level
Under this strategy, once the organisation sets its business goals, the hedge strategy fits into
place to protect those goals.

5. Crisis protection
A cheaper form of protection is to go further than protecting a specified profit level and cover
the danger level associated with the inability to service debt. This is normally cheaper than (4).

6. Protect downside but at zero premium outlay (zero cost collar)

Under this scenario a floor level is set, then the ceiling is calculated so that the premium
received for forfeiting the benefit from favourable rate movements fully offsets the cost
of the floor.

7. Tailor-made alternatives (knock-out option)

There is a range of other alternatives, one of which is a ‘knock-out option’, whereby, if rates move
sufficiently to make the prospect of a reversal to unacceptable levels unlikely, then the protection
or insurance for the option is ‘knocked out’ or rights under the option are extinguished.
 298 | INTEREST RATE RISK MANAGEMENT

The key IRRM financial instruments—swaps and options

Interest rate swaps
Interest rate swaps are one of the most widely used instruments for hedging interest rate risk
by Australian companies. In Australia, the reference rate in swap contracts is usually the BBSW.
The fixed interest rate in the swap transaction is called the swap rate. Typically, the swap rate is
set so that the swap is initially in effect of zero value to both parties. The party paying the fixed
(floating) rate is called the fixed (floating) rate payer. The fixed-rate payer in the swap is typically
the borrower, and the floating-rate payer is typically the bank.

Using the bank bill swap rate (BBSW) as the floating interest rate, the fixed-rate payer’s periodic
pay-off on the swap is:

Fixed-rate payer’s pay-offt = [BBSWt – Swap rate].

The floating-rate payer’s periodic pay-off on the swap is:

Floating rate payer’s pay-offt = [Swap rate – BBSWt]

where BBSWt is the BBSW prevailing at time t.

Thus, the fixed-rate payer’s pay-off is similar to the pay-off on an FRA. In fact, a swap can be
thought of as a portfolio of consecutive FRAs.

Consider an interest rate swap with cash flows exchanged annually and a tenor, or time to
maturity, of three years. The fixed-rate payer’s periodic pay-offs are:

Year 1: Fixed-rate payer’s pay-off1 = [BBSW1 – Swap rate]

Year 2: Fixed-rate payer’s pay-off2 = [BBSW2 – Swap rate]

Year 3: Fixed-rate payer’s pay-off3 = [BBSW3 – Swap rate].

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Interest rate options

When applied to interest rates, an option contract gives the buyer the right but not the
obligation to buy or sell an ‘asset’ at an agreed price on an agreed expiration date. The underlying
asset in an interest rate option is an interest rate, such as the BBSW or the bank‑accepted bill
rate. Interest rate options can be used to mitigate unfavourable changes in interest rates without
foregoing the benefits of favourable changes in interest rates. As with swaps, they can be used to
either partially or fully cover exposures in terms of both amounts exposed and time exposed.

Hedging with interest rate swaps

Interest rate swaps can be used to change an organisation’s interest rate risk profile (floating
to fixed or fixed to floating) without physically transacting in borrowing and lending markets.
Consider Conundrum Ltd in Example 5.3. The company has $100 million of annual coupon
floating-rate bonds on issue with four years remaining to maturity. The interest rate on the
floating-rate bond is the BBSW rate. How can Conundrum convert its floating interest rate
exposure to fixed-rate exposure?

The company has at least two alternatives.

First, it can retire the outstanding floating-rate bonds and issue new fixed-coupon bonds.
However, retiring old bonds and reissuing new bonds will be costly due to transaction costs,
advisory fees and compliance costs.
 Study guide | 299

Second, the organisation can use an interest rate swap. The swap is a single derivative contract
that synthetically transforms the floating interest rate exposure into fixed interest rate exposure.
Moreover, the swap not only eliminates uncertainty about future borrowing rates, but also
ensures that a single fixed borrowing rate applies for each period. Thus, the swap is a simple
structure that can transform an organisation’s interest rate risk profile without incurring the costs
associated with bond issues.

When transacting an interest rate swap, the terminology used to describe the swap relates to the
fixed leg of the swap. A borrower wanting to transact an interest swap to convert a floating rate
exposure to a fixed rate, would transact a pay fixed (receive floating) IRS. The borrower would pay
a fixed rate under the swap and receive a floating rate that would offset the floating rate paid on
the borrowing. A swap that converts fixed cash flows to floating is referred to as a receive fixed
(pay floating) IRS. The terminology of ‘pay fixed’ or ‘receive fixed’ is used rather than buy or sell.

Table 5.5 shows how a swap can be used to transform floating interest rate exposure to fixed
interest rate exposure.

Table 5.5: Transforming floating interest rate exposure to fixed interest rate
exposure using a swap

Cash flows

Floating-rate bonds – [BBSW]

Swap pay-off: Fixed-rate payer [BBSW – Swap rate]

Hedged position – [BBSW] + [BBSW – Swap rate] = – [Swap rate]

Example 5.3
Conundrum Ltd has a $100 million of floating rate bonds (face value), with interest rates set using
BBSW annual coupon bonds outstanding with four years to maturity. The organisation is concerned
that interest rates will increase and, hence, wants to move from floating interest rate to fixed interest
rate financing. How can the organisation convert its floating interest rate exposure to fixed interest

MODULE 5
rate exposure using a swap?

The organisation can transform floating interest rate exposure to fixed interest rate exposure by buying
an interest rate swap. Suppose the organisation buys an interest rate swap with a notional principal
of $100 million that requires payment of 7.81 per cent per annum in arrears and receives a BBSW that is
currently 5.00 per cent. What is the organisation’s new borrowing cost?

Cash flows

Floating-rate bonds – [BBSW]

Swap pay-off: Fixed-rate payer [BBSW – 7.81%]

Hedged position – [BBSW] + [BBSW – 7.81%] = – 7.81%

What are the organisation’s interest rate payments if the realised BBSW rates are as follows?

Year 0 1 2 3 4

Realised BBSW 5.00% 7.01% 9.03% 11.06%

Note: The floating rate applied to each periodic payment is set based on the floating rate at the
previous payment, so that the year 0 BBSW applies from years 0 to 1, the year 1 BBSW applies from
years 1 to 2, and so on.
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The organisation makes the following interest rate payments.

Year 1 2 3 4

Fixed-rate payer ($7 810 000) ($7 810 000) ($7 810 000) ($7 810 000)

Floating-rate receiver $5 000 000 $7 010 000 $9 030 000 $11 060 000

Net swap payments ($2 810 000) ($800 000) $1 220 000 $3 250 000

BBSW payments on bonds ($5 000 000) ($7 010 000) ($9 030 000) ($11 060 000)

Hedged position ($7 810 000) ($7 810 000) ($7 810 000) ($7 810 000)

Hedged position = [ – BBSW + (BBSW – Swap rate)]

Effectively, the organisation has locked in its borrowing costs at 7.81 per cent for the remaining term
of the bonds on issue.

Hedging with options—caps

Caps are designed to assist organisations to manage risk—normally to protect against interest
rate costs exceeding a specified level. Financial risk managers should not confuse what is
required—‘cap rate risk’—with how it is achieved—buying an interest rate call option. Further,
risk managers should ensure reports to the executive and board emphasise the underlying
reason for buying derivatives, rather than focusing on the derivatives themselves.

An interest rate cap is a call option where the underlying instrument is a floating interest rate.
A cap is an alternative to setting a trigger level for interest rate management and has the
advantage of locking in a known cost of insuring against rising costs and the certainty that it has
been negotiated—because if rates do rise, credit spreads may also increase and the effective
costs will therefore also rise.

As with all options, payment of a premium gives the buyer the right but not the obligation to
accept an agreed interest rate on an agreed date. It allows a variable rate borrower to retain the
advantage of their variable rate facility while obtaining the benefits of a maximum known cost
of borrowing. This is a trade-off between risk and return. A cap can consist of a series, or ‘strip’,
MODULE 5

of call options, tailored to the buyer’s requirements. The reference interest rate on caps in
Australia is normally the BBSW (bank swap rate) but could be any floating interest rate.

The strike or exercise interest rate on the cap is called the cap rate. If the reference interest
rate is greater than the cap rate on the expiration date, the cap buyer will exercise the option.
If the reference interest rate is less than or equal to the cap rate on the expiration date, the cap
buyer will not exercise the option. In this case, the cap expires and is worthless. Thus, the cap
buyer’s (long position) pay-off is:

Pay-off long cap = Max [BBSW – Cap rate, 0]

That is, the pay-off long cap is the maximum of (BBSW – Cap rate) or zero.

The cap buyer’s profit is equal to the cap’s pay-off minus the cap’s premium. Therefore, the profit
equation for a long cap is:

Profit long cap = Pay-off cap – Cap premium (CP) = Max [BBSW – Cap rate, 0] – CP
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The cap seller’s (short position) pay-off and profit equations are:

Pay-off short cap = – Max [BBSW – Cap rate, 0]

and

Profit short cap = CP – Max [BBSW – Cap rate, 0]

Hedging with caps

Interest rate caps can be used by borrowers to insure against high borrowing costs. The cap
buyer pays the cap seller a premium (either up-front or at expiration of the cap) to compensate
the seller against the possibility that the cap will be exercised. Thus, the use of caps to hedge
interest rate risk requires an outlay of funds, which increases the effective cost of borrowing.
If the cap is ‘in the money’ on the expiration date, the cap buyer will exercise the cap and use
the proceeds to offset the higher physical borrowing costs. On the other hand, if the cap is at or
‘out of the money’ on the expiration date, the buyer will let the option lapse and borrow at the
prevailing lower interest rate instead.

Example 5.4
Conundrum Ltd (Conundrum) has a $100 million borrowing requirement for 180 days in two months’
time. Conundrum will issue bank bills that are referenced to the BBSW floating rate and wishes to
hedge against increases in the cost of the borrowing. How can the company achieve this objective?

Conundrum can achieve its interest rate hedging objective by buying a cap. Assume the cap rate for
borrowing in two months’ time for 180 days is 5.00 per cent. Ignoring any cap premium, calculate the
company’s net cash flows and effective interest rate for the following BBSWs in two months’ time:
4.50 per cent, 5.00 per cent and 5.50 per cent.

The company’s net cash flows and effective borrowing rate for the three BBSW scenarios are as follows.

BBSW < Cap rate BBSW = Cap rate BBSW > Cap rate

4.50% 5.00% 5.50%

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Company’s gross proceeds $97 829 000.27 $97 593 582.89 $97 359 295.81

Long cap pay-off 0 0 $234 287.08

Company’s net proceeds $97 829 000.27 $97 593 582.89 $97 593 582.89

Effective borrowing rate 4.50% 5.00% 5.00%

(BBSW) (BBSW or cap rate) (Cap rate)

Gross borrowing proceeds

The company’s gross borrowing proceeds represents the amount of the borrowings that would have
applied if the cap was not in place. To calculate the gross borrowing proceeds, we use the PV formula
provided in Module 2:

PV = Principal / (1 + r (n / 365))

Note that the interest rate is multiplied by (n / 365) before adding 1.

So, where the BBSW is 4.50%:

PV = $100 000 000 / (1 + 0.045 × (180 / 365))

PV = $100 000 000 / 1.02219178

PV = $97 829 000.27

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Long cap pay-off

Where BBSW > Cap rate, there will be a long cap pay-off. Where BBSW is 5.50 per cent, the long cap
pay-off is derived by calculating the difference between the PV of the borrowing using the cap rate
of 5.00 per cent and the PV of the borrowing at 5.50 per cent.

PV using cap rate = $100m / (1 + 5.00% x (180 / 365)) = $97 593 582.89
PV using BBSW = $100m / (1 + 5.50% x (180 / 365)) = $97 359 295.81
Long cap pay-off: $97 593 582.89 – $97 359 295.81 = $234 287.08

When calculating the pay-off for the long cap in dollar terms rather than percentages, the pay-off
formula used is Max [(Cap PV – BBSW PV), 0], instead of Max [BBSW – Cap rate, 0].

Net borrowing proceeds

The company’s net proceeds represents the effective amount of the borrowings after taking into
consideration the cap. When the BBSW is 5.50 per cent, this is calculated as: $97 359 295.81 +
$234 287.08 = $97 593 582.89.

Effective borrowing rate

The effective borrowing rate is the interest rate that the company actually achieves, as shown below.

Scenario Effective rate

If BBSW < Cap rate BBSW
If BBSW = Cap rate BBSW or Cap rate
If BBSW > Cap rate Cap rate

Conundrum has capped its interest rate exposure at 5.00 per cent. If the reference rate is below the
cap rate, the effective borrowing rate is the reference rate (i.e. BBSW) and there is no pay-off from
the long cap. But, if the reference rate is greater than the cap rate, the effective borrowing rate is the
cap rate (i.e. 5.00%) and so there is a pay-off from the long cap.

With BBSW at 5.50 per cent, Conundrum borrows at 5.50 per cent then receives a 0.50 per cent pay-off
from the cap (i.e. Pay-off long cap = Max [BBSW – Cap rate, 0]), which reduces the effective borrowing
rate to 5.00 per cent.

This example ignores the premium that would be charged on a cap. However, the premium would
reduce the pay-off from the long cap and add to the effective borrowing rate. Assuming a cap premium
of 0.10 per cent, the effective borrowing rates would increase by this amount.
MODULE 5

Where BBSW < Cap, the cap would lapse unexercised, the pay-off from the long cap would be
–0.10 per cent and the effective borrowing rate would be 4.60 per cent (i.e. 4.50% + 0.10%).

Where BBSW = Cap, the cap may or may not be exercised. Either way, the pay-off from the long cap
would be –0.10 per cent and the effective borrowing rate would be 5.10 per cent (i.e. 5.00% + 0.10%).

Where BBSW > Cap, the cap would be exercised, the pay-off from the long cap would be 0.40 per
cent (i.e. 0.50% – 0.10%) and the effective borrowing rate would be 5.10 per cent (i.e. 5.00% + 0.10%).

In this example, we are calculating the present value of the debt that would apply in two months’
time. We have not attempted to calculate the present value of the debt as at today. As such, this is a
different, simpler, example to those that are later in the module, which calculate fair values as at today.
 Study guide | 303

➤➤Question 5.1
Borrowlots Ltd has a $40 million face value borrowing requirement for 120 days beginning in three
months’ time, and wishes to protect itself against an interest rate increase above 7.50 per cent
but enjoy the benefit of lower rates. How can Borrowlots Ltd achieve this objective?
Ignoring the cap premium, calculate Borrowlots Ltd’s physical borrowing proceeds and cash flows
associated with the hedging instrument if the BBSW in three months is:
• 6.00 per cent.
• 7.50 per cent.
• 9.00 per cent.

Floors
An interest rate floor is a put option where the underlying instrument is a floating interest rate.
A floor gives the buyer the right but not the obligation to accept an agreed interest rate on an
agreed expiration date. It allows a variable rate investor to retain the upside advantage of their
variable rate investment while obtaining a known minimum interest rate. A floor can be one or a
series of interest rate put options, each having a different expiration date. The reference interest
rate on floors is BBSW. The strike or exercise interest rate on the floor is called the floor rate.
If the reference interest rate is less than the floor rate on the expiration date, the floor buyer will
exercise the option. If the reference interest rate is greater than or equal to the floor rate on the
expiration date, the floor buyer will not exercise the option. In this case, the floor expires and is
worthless. Thus, the floor buyer’s (the long position’s) pay-off is:

Pay-off long floor = Max [Floor rate – BBSW, 0]

The floor buyer’s profit is equal to the floor’s pay-off minus the floor premium. Therefore,
the profit equation for a long floor is:

Profit long floor = Pay-off floor – Floor premium (FP) = Max [Floor rate – BBSW, 0] – FP

The floor seller’s (the short position’s) pay-off and profit equations are:

MODULE 5
Pay-off short floor = – Max [Floor rate – BBSW, 0]

and

Profit short floor = FP – Max [Floor Rate – BBSW, 0]

Hedging with floors (as part of a collar)

Interest rate floors are used by borrowers to decrease the cost of buying caps—that is,
borrowers sell a floor to a bank and in return receive a premium. If the floor is ‘in the money’
on the expiration date, the bank exercises the floor. On the other hand, if the floor is at or
‘out of the money’ on the expiration date, the bank will let the option lapse.
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Interest rate collars

For a corporate treasurer, an interest rate collar involves simultaneously purchasing a cap and
selling a floor. The collar is attractive for borrowers because the cost of the bought cap can
be offset by the premium received on the sold floor. In fact, it is possible to create a zero cost
collar. In a zero cost collar, the premium received on the sold floor exactly offsets the cost of the
purchased cap, so the corporate treasurer has no up-front expense. For borrowers, zero cost
collars can protect against high borrowing costs by placing a ceiling on interest rates without
incurring any initial expense. However, the opportunity cost of the collar is that borrowers do not
fully benefit from falling interest rates because the sold put option places a floor on interest rates.
Explicitly, if interest rates fall below the floor rate, the floor is exercised and the borrower transfers
the benefits from lower interest rates to the floor buyer.

The buyer’s (the long position’s) pay-off on a collar is:

Pay-off long collar = Max [BBSW – Cap rate, 0] – [Max [Floor rate – BBSW, 0]]

The buyer’s profit on the collar is:

Profit long collar = {Max [BBSW – Cap rate, 0] – [Max [Floor rate – BBSW, 0]]} – {CP – FP}

If the collar is a zero cost collar, CP = FP and the profit equation simplifies to the payoff equation.

Hedging with collars

An interest rate collar simultaneously places a ceiling and a floor on interest rates. The collar is
attractive to borrowers because the cost of the hedging strategy to borrowers is lower than a
hedging strategy using caps. However, as discussed previously, the opportunity cost of hedging
with collars is that the borrower does not retain the full benefits of falling interest rates.

Example 5.5
Conundrum Ltd (Conundrum) has a $100 million borrowing requirement for 180 days being rolled
over in two months’ time. Conundrum wishes to hedge against increases in the cost of borrowing.
MODULE 5

However, the hedge strategy must maintain some of the benefits of falling interest rates, but require
no initial outlay. How can Conundrum achieve this objective? Assume that a cap with a cap rate of
8.00 per cent can be bought and a floor with a floor rate of 4.00 per cent is sold for the same premium.

Conundrum’s hedging objective can be achieved by purchasing a collar that involves simultaneously
buying the 8.00 per cent cap and selling the 4.00 per cent floor. Calculate the effective borrowing rate
if the realised BBSW in two months’ time is 2.00 per cent, 5.00 per cent or 10.00 per cent.

Since the collar places a ceiling and floor on interest rates, Conundrum’s borrowing cost will be equal
to or between the floor rate of 4.00 per cent and the cap rate of 8.00 per cent. Conundrum’s effective
borrowing rates for the three BBSW scenarios are as follows.

Scenario 1 Scenario 2 Scenario 3

Realised BBSW 2.00% 5.00% 10.00%

Borrowing cost 2.00% 5.00% 10.00%

Long cap pay-off 0 0 2.00%

Short floor pay-off (2.00%) 0 0

Effective borrowing rate 4.00% 5.00% 8.00%

(floor rate) (BBSW) (cap rate)
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Long cap pay-off

The long cap pay-off is calculated as Max [BBSW – cap rate, 0].

Conundrum has capped the rate at 8 per cent. As such, the long cap pay-off in Scenarios 1 or 2 is
zero, as the BBSW rate is lower than 8 per cent. However, in Scenario 3, the BBSW rate is 10 per cent
and so the long cap pay-off is 2 per cent (i.e. 10% – 8%).

Short floor pay-off

The short floor pay-off is calculated as –Max [Floor rate – BBSW, 0].

Conundrum also has a floor rate which is 4 per cent. As such, the short floor pay-off in Scenarios 2 and
3 is zero, as the BBSW rate is higher than 4 per cent. However, in Scenario 1, the BBSW rate is 2 per
cent and so the short floor pay-off is –2 per cent (i.e. –(4% – 2%)).

Result
With the collar arrangement, the maximum effective borrowing rate will be 8 per cent and the minimum
effective borrowing rate will be 4 per cent.

➤➤Question 5.2
Consider an organisation that has issued $100 million face value, 6.90 per cent annual coupon
bonds with four years to maturity. The organisation is concerned that interest rates will decrease.
How can the organisation convert its fixed interest rate exposure to floating interest rate exposure
using a swap?
Calculate the organisation’s interest rate payments on the swap if the realised BBSW rates are
as follows.

Year 0 1 2 3

BBSW 7.00% 5.01% 3.03% 1.06%

Interest rate swaptions

A swaption is an option to enter into a certain interest rate swap at a certain time in the future.
Swaptions are classified as either payer swaptions or receiver swaptions. The buyer of the

MODULE 5
payer swaption has the right, but not the obligation, to enter into a swap in which the buyer pays
the fixed swaption rate. Hence, the buyer of a payer swaption has the right to receive floating
interest payments and pay fixed interest payments. The buyer of the payer swaption will exercise
the right to enter into the swap and pay the fixed swaption rate if swap rates increase above the
swaption rate (fixed rate). The buyer of the receiver swaption has the right but not the obligation
to enter into a swap in which he or she receives the fixed swaption rate. Hence, the buyer of
the receiver swaption has the right to receive fixed interest payments and pay floating interest
payments. The buyer of the receiver swaption will exercise the right to enter into the swap and
receive the fixed swaption rate if swap rates decrease below the swaption rate.

The buyer’s pay-off on a payer swaption is:

Pay-off long payer swaption = Max [Swap rate – Swaption rate, 0]

The buyer’s profit on a payer swaption is:

Profit long payer swaption = Max [Swap rate – Swaption rate, 0] – Payer swaption premium

The buyer’s pay-off on a receiver swaption is:

Pay-off long receiver swaption = Max [Swaption rate – Swap rate, 0]

 306 | INTEREST RATE RISK MANAGEMENT

The buyer’s profit on a receiver swaption is:

Profit long receiver swaption = Max [Swaption rate – Swap rate, 0] – Receiver swaption premium

Hedging with swaptions

Swaptions can be used by organisations to manage the interest rate risk associated with their
actual or planned borrowing programs. The buyer of a swaption, typically a borrower such as
Conundrum Ltd, pays the seller, typically a bank, an up-front premium to compensate the seller
against the possibility that the swaption will be exercised. An organisation that plans to borrow
floating-rate funds and immediately swap the floating interest rate exposure to fixed interest
rate exposure can buy a payer swaption to protect against rising interest rates. If, when the
organisation borrows, the prevailing market swap rate is greater than the swap rate on the
swaption, the organisation exercises the swaption and enters into a swap in which it receives the
floating rate and pays the fixed rate. A borrower that buys payer swaption with a fixed rate of
7 per cent would have the right but not the obligation to exercise the swaption and enter into a
pay fixed swap with a fixed rate of 7 per cent. If the prevailing market swap rate on the expiration
date is less than the swap rate on the swaption, the buyer of the payer swaption will let the
option lapse and the organisation enters into a swap at the prevailing lower swap rate.

Example 5.6
Conundrum Ltd plans to borrow additional floating-rate funds in six months and immediately swap the
floating interest rate exposure to fixed-interest rate exposure for three years. Conundrum is concerned
that interest rates will rise and wants to hedge against this risk. However, it also wants to maintain
the benefits provided by an interest rate decrease. How can the company achieve this objective?

Conundrum can achieve its objective by entering into a payer swaption. The buyer of the payer swaption
has the right, but not the obligation, to enter into a swap in which the organisation pays the fixed rate
and receives the floating rate. Suppose that the swap rate on the payer swaption is 7.00 per cent and
assume that the swap rate on offer at expiration of the swaption is either 6.00 per cent or 8.00 per cent.
Ignoring any swaption premium, calculate the organisation’s pay‑off on the payer swaption.

The organisation’s pay-off on the payer swaption is:

MODULE 5

Pay-off long payer swaption = Max [Swap rate – Swaption rate, 0]

Swap rate < Swaption rate Swap rate > Swaption rate

Swap rate in six months 6.00% 8.00%

Exercise swaption? No Yes

Pay-off payer swaption 0 1.00%

Hedged borrowing rate 6.00% 7.00%

So, if the swap rate is at 6.00 per cent, the borrower will allow the swaption to expire worthless and
enter into a swap at 6.00 per cent. If the swap rate is 8.00 per cent, the borrower will exercise the
swaption and enter into the swap at 7.00 per cent. Max [8.00 – 7.00, 0] =1.00. BBSW is not relevant.
 Study guide | 307

➤➤Question 5.3
An organisation plans to issue long-term, floating-rate debt in two years’ time and immediately swap
the floating interest rate exposure to fixed interest rate exposure. The organisation is concerned
about rising interest rates and wants to hedge against this risk. However, the organisation wants
to maintain the benefits provided by an interest rate decrease. How can it achieve this objective?
Suppose that the swap rate today on a payer swaption is 4.00 per cent. Ignoring any swaption
premium, calculate the organisation’s effective borrowing rate if the swap rate on offer in two
years’ time is:
(a) 3.50 per cent.
(b) 4.00 per cent.
(c) 4.50 per cent.

Step 5: Accounting and controls

The final stage of the financial risk management process is covered in detail in Modules 7 and 8.

Accounting for interest rate risk products

Under the accounting standard IAS 39, all derivatives, including IRRM products, must be recorded
on the statement of financial position at their fair value over the life of the derivative. For IRRM,
the hedge arrangement is most often a cash flow hedge—that is, where the hedge fixes an
otherwise variable cash flow that will affect the profit and loss statement. Under a cash flow hedge,
if the derivative qualifies for hedge accounting, all fair value gains or losses can be recorded in the
statement of financial position and then recognised in the statement of comprehensive income
in the same period that the underlying transaction is recorded in the profit and loss statement.
The calculation of fair value for interest rate derivatives is explained below.

To achieve hedge accounting a number of steps need to be taken, including specific hedge
documentation and hedge effectiveness testing of each hedge. Full details on hedge
accounting, including cash flow hedges, have been included in Module 7.

MODULE 5
Fair valuing interest rate derivatives
IAS 39 requires all derivatives to be measured at fair value and recorded on the balance
sheet of corporations. Fair value is described as being the amount for which an asset could
be exchanged, or liability settled, between knowledgeable, willing parties in an arm’s-length
transaction. See Module 7 for more details.

The change in fair value of a derivative is recorded directly to profit and loss unless the derivative
is part of a qualifying hedge relationship (i.e. a cash flow hedge). The calculation for the fair value
forms a key part of accounting for derivatives. The methodology for calculating the fair value of
interest rate swaps is shown in Example 5.7. The valuation of interest rate options is beyond the
scope of the subject. However, the fair value calculations of interest rate swaps are within the
scope. Example 5.8 has been provided for illustrative purposes only.

Note: There are a number of ways to value interest rate swaps. The methodology in Example 5.7
is an accepted Australian market practice.
 308 | INTEREST RATE RISK MANAGEMENT

Example 5.7
Fair value calculation—interest rate swaps
On 30/06/2015, Bigprofits Ltd borrowed $1 million on a floating-rate basis and entered into an interest
rate swap to pay a fixed rate of 8.00 per cent for three years and receive BBSW + 1.00 per cent.
Note that the interest rate swap has a zero fair value at inception.

On 30/06/2016, the fair value of the interest rate swap is required so that the derivative can be recorded
on the statement of financial position.

This requires the applicable interest rate to each future cash flow date to discount them to 30/06/2016.
(Note that the interest payments due under the swap on 30/06/2016 are excluded from the calculation
as they should have been made on that day.)

The present values of the fixed-rate and floating-rate cash flows are netted off to obtain the fair value.

The generally accepted approach for calculating discount factors for this purpose is to use a technique
called ‘bootstrapping’ to derive a curve with no interest payments (called the zero curve, or more
fully, a zero coupon fixed income yield curve), from which any yield can be priced, whether spot or
forward. Bootstrapping is an iterative process that first calculates a single ‘par’ or zero coupon price
point, then uses derived information to calculate a further par price and continues the process to
gradually link all prices (just as a bootstrap laces a shoe together) to calculate a zero coupon curve
using a ‘bootstrapping’ methodology.

Note that, following the introduction of IFRS 13, a credit valuation adjustment (CVA) is required to be
estimated. This is often done by adding a counterparty specific credit spread to the interest rates used.

However, for the purposes of this exercise, both the calculation of the zero curve and the estimation
of a CVA will be ignored and the calculation of discount factors will use the following simplified formula:

1
Discount factor = d
(1 + r ) 365

where:
r is the interest rate
d is the number of days between the valuation date and the date of the cash flow.
MODULE 5

Valuing the floating leg of the transaction requires ‘forward’ interest rates to be calculated. This is the
interest rate applicable to the forward floating rate interest period (i.e. the period from 6 months to 1 year).

Think of this as the effective interest rate achieved by borrowing for six months and lending for one
year. The formula for this is:

 DFnear  365
Forward rate =  − 1 ×
 DFfar  d
where:
DFnear is the discount factor at the near (or earlier) date
DFfar is the discount factor at the far date
d is the number of days between near and far dates.

Deal date 30/06/2015

Maturity date 30/06/2018

Notional principal 1 000 000

Fixed rate 8% Semi-annual interest

Floating rate 6-month BBSW + 1.00% Semi-annual interest

Fair value at inception Nil

 Study guide | 309

Valuations as at 30/6/2016

Market rates Maturity date Market rate1 Discount factor1 6-month forward rate2

6-month BBSW 30/12/2016 5.00% 0.97583

1 year swap 30/06/2017 5.50% 0.94787 5.92%

18-month swap 30/12/2017 5.75% 0.91949 6.16%

2-year swap 30/06/2018 6.00% 0.89000 6.65%

Value of the floating leg

Rate
Floating Floating set or
period period forward Floating Floating Discount Present
start date end date rate3 Margin rate coupon4 factor value5

30/06/2016 30/12/2016 5.00% 1.00% 6.00% 30 082.19 0.97583 29 355.10

30/12/2016 30/06/2017 5.92% 1.00% 6.92% 34 484.02 0.94787 32 686.37

30/06/2017 30/12/2017 6.16% 1.00% 7.16% 35 878.63 0.91949 32 990.04

30/12/2017 30/06/2018 6.65% 1.00% 7.65% 38 121.13 0.89000 33 927.81

128 959.32

Value of the fixed leg

Fixed period Fixed period Fixed Fixed Discount Present

start date end date rate coupon4 factor value5

30/06/2016 30/12/2016 8.00% –40 109.59 0.97583 –39 140.14

30/12/2016 30/06/2017 8.00% –39 890.41 0.94787 –37 810.92

30/06/2017 30/12/2017 8.00% –40 109.59 0.91949 –36 880.37

30/12/2017 30/06/2018 8.00% –39 890.41 0.89000 –35 502.47

–149 333.90

MODULE 5
The value of the swap is the sum of the values of the fixed and floating legs, or –$20 374.58
(i.e. –$149 333.90 + $128 959.32).

Notes:
1
The market rates have been provided and are used to calculate the discount factors. The discount factors are
calculated using the discount factor formula provided above. For example, the discount factor for the 6-month
BBSW is: 1 / (1 + 0.05)(183 / 365) = 0.97583.
2
The 6-month forward rates are calculated using the forward rate formula provided above. For example,
the 6-month forward rate for the 18-month swap is: ((0.94787 / 0.91949) – 1) x (365 / 183) = 0.0616 or 6.16%.
3
The rate set, or forward rate, has been rounded to two decimal places in the table (e.g. 5.92% for the floating
period starting 30/12/2016). However, note that in calculating the floating coupons, non-rounded rates have
been used (e.g. 5.915752%).
4
The floating and fixed coupons are calculated by applying the floating or fixed rate (as applicable) to the
notional principal for the relevant number of days in the period. For example, the period 30/06/2016 to
30/12/2016 has 183 days and the floating coupon calculation is: $1 000 000 x (0.06 × (183 / 365)) = $30 082.19.
5
The present value is calculated by applying the discount factor to the floating or fixed coupon amount.
For example, for the floating period starting 30/06/2016, the calculation is: $30 082.19 × 0.97583 = $29 355.10.
 310 | INTEREST RATE RISK MANAGEMENT

Example 5.8
Fair value calculation—interest rate options
On 1/05/2015 Bigprofits Ltd anticipates borrowing $1 million in three months’ time and purchases an
interest rate cap (call option) with a strike rate of 6.00 per cent.

On 30/06/2015 the fair value of the interest rate cap is required so that the derivative can be recorded
on the balance sheet. The following information is needed to calculate the fair value as at 30/06/2015:
(a) the risk free rate, (b) interest rate volatility, and (c) forward 90-day BBSW rate as at 01/08/2015.

The following data has been assumed and calculated at fair value.

Deal date 1/05/2015

Underlying instrument 90-day BAB
Fair value at inception $3000
Expiration date 1/08/2015
Valuation date 30/06/2015
Days to expiration 32

Notional principal $1 000 000.00

Forward rate (f ) 7.5%
Strike rate ( x) 6.00%
Volatility (σ ) 20.00%
d1 3.798
d2 3.739
N(d1) 1.000
N(d2) 1.000
Time (t) (years 32/365) 0.088
Risk-free rate (r) 5.50%
N(–d1) 0.000
N(–d2) 0.000

= (
c e −rt fN (d 1 ) − xN (d2 ) )
 f  σ 
2
Ln   +   t
MODULE 5

x  2 
d1 =
σ t

d=
2 d1 − σ t

 0.075   0.2 
2
Ln  +  0.088
 0.06   2 
d1 =
0.2 0.088

d2 =
3.798 − 0.2 0.088 =
3.739

=c e −0.055 × 0.088 × ( 0.075 × 1 − =

0.06 × 1) 0.01492792

where:
c = cap value per $1
e = the mathematical constant with value of 2.718
r = risk-free rate
f = forward rate
x = strike rate
σ = volatility
t = time to expiration
N = normal cumulated distribution function
 Study guide | 311

Note 1: ‘Ln’ refers to the Log or logarithmic function. On your scientific/financial calculator, you should
have a button for ‘ln’. So, to calculate Ln(f / x) as per the d1 equation, you would enter: (0.075 / 0.06)
ln = 0.22314.
Note 2: While the valuation of interest rate options is beyond the scope of this subject, the fair value
calculations of interest rate swaps are within the scope of the subject.

Fair value = Cap value x Notional principal = 0.01492792 × $1 000 000

Fair value = $14 927.92

➤➤Question 5.4
You have been asked to calculate the fair value of a pay fixed interest rate swap for 30 June 2015
year end. Please show all workings.
The deal details are:
Deal date 30/06/2014
Fair value at inception $0.00
Maturity date 30/06/2017
Notional principal $10 000 000.00
Fixed rate 7.00%
Floating rate BBSW + 1.00%
Time to expiration (years) 2
Frequency annual
Valuation date 30/06/2015

Date Discount factor

30/06/2016 0.952
30/06/2017 0.898

Floating leg rates

Date Forecast rate Margin Floating rate
30/06/2016 6.00% 1.00% 7.00%
30/06/2017 7.00% 1.00% 8.00%

Interest rate risk reporting

MODULE 5
An important part of IRRM is the reporting of all positions to the board so that informed
decisions are made. The board’s financial risk management reports should cover all types of
financial risk, including liquidity and funding positions and interest rate exposures.

An example of a chart for long-term IRRM is shown in Figure 5.15. From this chart,
the organisation can observe the current position of its interest rate hedge profile,
including estimated debt, the types of hedges and the periods the hedges are covering,
compliance with maximum and minimum hedging limits, and the average fixed rate it
is achieving in each year. By reporting options separately from the fixed-rate hedges,
individual directors may consider the options as either fixed or floating, depending on
their view of future interest rate movements.
 312 | INTEREST RATE RISK MANAGEMENT

Figure 5.15: Long-term interest rate hedging

Estimated
$ debt Floating Minimum hedge
Options Maximum hedge
Fixed
400

350

300

250

200

150

100

50

0
20X1 20X2 20X3 20X4 20X5
Future years

An example of a chart for short-term IRRM is shown in Figure 5.16. This chart depicts the degree
of hedging during the current year and may be produced on a monthly or quarterly basis.
Compliance with maximum and minimum hedging limits may also be included. However, in times
of historically low interest rates and low interest rate volatility, many corporations are not as
concerned with monitoring short‑term IRRM.

Figure 5.16: Short-term interest rate hedging

Estimated
$ debt Floating
Caps
MODULE 5

Fixed
400

350

300

250

200

150

100

50

0
J F M A M J J A S O N D
Month

In addition to monitoring the hedges against forecast debt levels, many organisations also
undertake sensitivity analysis to determine what impact a sudden increase or decrease in
interest rates will have on the organisation’s interest expense. Table 5.6 provides an example
of sensitivity analysis.
 Study guide | 313

Table 5.6: Interest rate sensitivity analysis

Base scenario Sensitivity—rising rates Sensitivity—falling rates

Principal Interest Interest Interest

($m) Rate ($m) +0.50% ($m) –0.50% ($m)

Fixed $250 5.65% $14.125 5.65% $14.125 5.65% $14.125

Caps $35 5.75% $2.013 5.75% $2.013 5.25% $1.838

Floating $35 5.50% $1.925 6.00% $2.100 5.00% $1.750

Total $320 5.64% $18.063 5.70% $18.238 5.54% $17.713

The weighted average interest cost is 5.64 per cent or $18.063m. If rates rise by 0.50 per cent, the only
interest increase is in the floating-rate borrowing. There is no change to the fixed or capped rates.
The weighted average interest cost increases to 5.70 per cent or $18.238m. If rates fall by 0.50 per cent,
there is no change to the fixed borrowing but there is a 0.50 per cent reduction in the capped and floating
borrowing. The weighted average interest cost declines to 5.54 per cent or $17.713 million.

More advanced organisations will also report their performance in managing interest rate risk against
an agreed benchmark and will provide details of the IRRM strategies management is pursuing and/or
contemplating.

➤➤Question 5.5
An organisation has placed a tender for $75 million to purchase land to develop either:
• a low-rise resort at a cost of $50 million; or
• a multi-storey holiday apartment complex at a cost of $100 million.
The results of the tender will be known in approximately three months’ time and, if successful,
the organisation will lodge a planning application immediately after the conclusion of the tender
process. Planning approval is expected to take 12 months and, once granted, construction
will commence. It is anticipated it will take 12 months to construct and sell the development.
Either choice of project will be fully funded.

MODULE 5
Tender
results Commence Sell
known building asset

Year 1 Year 2
Submit tender

Quarter 0 1 2 3 4 5 6 7 8 9

The entire project is sensitive to interest rate movements, so the organisation would like to protect
itself from increases in interest rates. However, it expects a change in government will result in
lower interest rates and wishes to benefit from decreases in interest rates.
The only transactions currently available and the interest rates are as follows.

Immediate start
3-month BBSW 5.25%
6-month BBSW 5.50%
1-year swap 6.00%
2-year swap 6.50%
 314 | INTEREST RATE RISK MANAGEMENT

Starting in 3 months Swaption Swaption

Transaction Cap Floor Payer Receiver Payer Receiver
Term 1 year 1 year 1 year 1 year 2 years 2 years
Strike 6.25% 6.20% 6.25% 6.20% 6.75% 6.70%
Premium 0.35% 0.35% 0.35% 0.35% 0.55% 0.55%

Starting in 6 months Swaption Swaption

Transaction Cap Floor Payer Receiver Payer Receiver
Term 1 year 1 year 1 year 1 year 2 years 2 years
Strike 6.45% 6.40% 6.45% 6.40% 6.95% 6.90%
Premium 0.45% 0.45% 0.45% 0.45% 0.65% 0.65%

Starting in 15 months Swaption

Transaction Payer Receiver
Term 1 year 1 year
Strike 6.65% 6.60%
Premium 0.65% 0.65%

(a) What hedging strategy would you recommend (transactions, amounts, dates or rates)?
(b) On the expiration date of the hedge transactions, what would happen if the prevailing interest
rates were 1.50 per cent higher than the hedged rates?
(c) On the expiration date of the hedge transactions, what would happen if the prevailing interest
rates were 1.50 per cent lower than the hedge rates?
(d) What would be the cost or benefit of hedging when compared to having done nothing under
each scenario?
(e) How would you advise the corporation to manage its hedging transactions?
MODULE 5
 Study guide | 315

Review
This module presented a systematic approach to the management of interest rate risk.
Having established the context in which interest rate risk management (IRRM) is conducted,
there followed a detailed outline of the operational issues involved. The final section provided a
series of worked examples to illustrate the operational aspects of IRRM.

MODULE 5
MODULE 5
 Appendix 5.1 | 317

Appendix
Appendix

Appendix 5.1
Case study

Embedded options—the Bond Corporation case

Background
In the late 1980s ABC television screened a documentary on its current affairs program
Four Corners. The program outlined the disparity between reported and actual profits and
cash flows of the Bond Corporation.

MODULE 5
Bond Corporation undertook a complex sale of land transaction that was designed to make a
loan appear as a profit, thereby enhancing the financial performance of the entity.

It worked.

The presentation of inflated returns resulted in positive feedback for the professional analysts
and allowed Bond Corporation to borrow hundreds of millions of dollars in the following
financial year.

In this case study, which has simplified the numbers but little else, your goal is to attempt to identify
the true state of affairs. Put yourself in the position of a superannuation fund’s CFO proposing to
invest in Bond Corporation.
 318 | INTEREST RATE RISK MANAGEMENT

The commercial agreement

Bond Corporation owned land and buildings in Italy’s capital, Rome, that it had agreed to sell
for AUD 100 million (the sale was to be made in AUD to avoid any foreign exchange issues for
Bond Corporation).

However, Bond Corporation believed there could be a property boom in Italy, so it was willing
to pay the purchaser $20 million for the right to repurchase the property for the original amount
of AUD 100 million for up to 12 months after the signing of the original contract. The buyer was
to be given a ‘sweetener’ allowing it to abandon the deal in 12 months’ time if property prices
fell (or any other reason). The land title would be returned to the seller on repayment of the
AUD 100 million to the purchaser.

Here is a synopsis of the contract (warning: beware legalese designed to complicate matters):

Bond Corporation

Contract of Sale

Whereas it is therefore agreed, inter alia, between

Bond Corporation ACN1523672, hereinafter described as the Vendor

and

Roma Land Internazionale, hereinafter referred to as the Purchaser

that:

1. The
 Purchaser to take possession of the properties included in the area bounded by the
Cortile della Pigna, the Stradone ai Giardini and the Cortile della Corazze.
2. The Purchaser to deliver to Chemical Bank New York, for a/c 23-454-001-2, the sum of
AUD 100 000 000.00 for value 30 May 1987.
MODULE 5

3. The vendor to contract absolutely to permit the Purchaser to return all deeds relating to the
properties referred to in Paragraph [1] above for the sum referred to in Paragraph [2] above
on 30 May 1988, with all monies delivered to Citibank New York for a/c RLI 122 545 654.
4. The vendor to pay consideration of AUD 20 000 000.00 to the account referred to in
Paragraph [3] above for value 30 May 1987 for the right to repurchase all lands referred to
in Paragraph [1] above for a sum of AUD 100 000 000.00 payable to the account referred
to in Paragraph [3] above on 30 May 1988.
5. All other contractual undertakings, covenants and warrants to be as per the Principal Master
Agreement, registered number 87/1628365.
6. Legal code applying is that of Great Britain and Northern Ireland.

Signed this …20th….day of …May… 1987…

………………………..…………………… ………………………..……………………
for and on behalf of Bond Corporation Witness

………………………..…………………… ………………………………………………
for and on behalf of Roma Land Internazionale Witness
 Appendix 5.1 | 319

What does the agreement actually entail?

(a) A sale and leaseback arrangement.
(b) A commercial sale with embedded options.
(c) A transfer pricing arrangement shifting funds into Australia.
(d) A secured mortgage.

Please nominate your answer before proceeding.

A revised version of the contract

Below is a plain English version of the previous contract.

Sale of Land (in Rome)

Seller: Bond Corporation

Buyer: Roma Land Internazionale

Conditions agreed:

1. B ond Corporation to sell the land for AUD 100 million to Roma Land Internazionale.
2. Roma Land Internazionale has the right to sell the land back to Bond Corporation in one
year’s time for AUD 100 million.
3. Bond Corporation will pay AUD 20 million to Roma Land Internazionale for the option to buy
back the land in a year’s time and return the AUD 100 million.

What is your assessment of the deal after receiving the revised version of the contract?
(a) A sale and leaseback arrangement.
(b) A commercial sale with embedded options.
(c) A transfer pricing arrangement shifting funds into Australia.
(d) A secured mortgage.

MODULE 5
Please again nominate your answer before proceeding.

Answers to case study questions

The correct answer to the case study is alternative (d). Details follow.

Answer (a) is incorrect because there is no leaseback arrangement involved.

Answer (b) is incorrect due to the option clauses. It is actually not a sale—see answer (d).
Answer (c) is incorrect because there is no ultimate transfer of funds.

Answer (d) is correct.

From the first (long-winded) contract:

Paragraphs 1 and 2: Bond Corporation sells the land for AUD 100 million.

Paragraph 4: Bond Corporation reduces the cost of the land to AUD 80 million in return for
the right (option) to buy back the land for the original AUD 100 million for what appears to be
a net loss of AUD 20 million (unless it is viewed as interest on the AUD 80 million borrowed,
about 25% p.a.).
 320 | INTEREST RATE RISK MANAGEMENT

Paragraph 5: The purchaser is able to regain its funds in a year by returning the title documents.

So, if land prices fall, the purchaser could exercise its option; if land prices rise, Bond Corporation
could exercise its option. If land prices remain unchanged, either party could exercise the option.

In summary:

Figure A5.1: B
 ond Corporation Roma Land deal loan agreement:
Plain language version

Borrower: Bond Corporation

Lender: Roma Land

Conditions of mortgage:
• Bond Corporation to borrow $80 million for one year.
• Interest rate fixed at 25 per cent per annum effective, payable quarterly.
• The loan to be secured against properties as specified.

Figure A5.2: Roma Land 1 embedded options

This shows the position prior to any financial engineering.

Bond’s view
(year end)

Land Land
depreciates appreciates

$100 million
MODULE 5
 Appendix 5.1 | 321

Figure A5.3: Roma Land 2 embedded options

This reflects the $20 million cost of Bond Corporation repurchasing the land.

Bond’s view
(year end)

Option to rebuy

Land Land
depreciates appreciates

$20 million

Buyer’s option to sell

What Bond Corporation really ends up with is the land plus an interest bill for $20 million.
The two options in Figures A5.2 and A5.3 combine to give the final picture below.

Compare it to the first of these three diagrams for the ‘before’ and ‘after’ pictures.

This assumes no change in value of the land.

Figure A5.4: Roma Land 3 embedded options

Bond’s view Combination of to rebuy

(year end) and buyer’s option to sell

MODULE 5
Land Land
depreciates appreciates
$20 million interest
(25% p.a.)
 322 | INTEREST RATE RISK MANAGEMENT

Implications for Bond Corporation

Why would Bond Corporation go to such lengths? As stated in the introduction, this was
designed to make a loan appear as a profit, thereby enhancing the financial performance of
the entity. By doing so, Bond Corporation announced profits on the sale of land in Rome,
which improved the company’s cash position and net profit. Analysts were impressed and banks
accepted the analysts’ views and increased the lending to Bond Corporation.

This example of financial engineering is more common than most people would realise and
you should be careful not to confuse reported results with the underlying financial heath
of the organisation.

In summary:

What Bond did: What Bond should have done:

Performance variable Financial engineering Secured mortgage

1. Cash flow Increased Increased

2. Profit Improved Worsened

(Increased borrowing costs)

3. Gearing Improved Worsened

4. Reported in accounts? Only in notes to the accounts Yes

5. Detected by analyst? No Yes

6. Effect on rating? Improved Worsened

MODULE 5
 Suggested answers | 323

Suggested answers
Suggested answers

Question 5.1
Borrowlots Ltd will buy an interest rate cap under which it will pay a maximum interest rate of
7.50 per cent by exercising the cap if BBSW is higher than 7.50 per cent in three months’ time;
otherwise, it will allow the cap to lapse and pay the lower BBSW rate.

The borrowing proceeds and hedging cash flows will be as follows.

BBSW < Cap rate BBSW = Cap rate BBSW > Cap rate
6.00% 7.50% 9.00%

Borrowlots Ltd gross proceeds $39 226 222.46 $39 037 433.16 $38 850 452.37

Long cap pay-off 0 0 $186 980.79

MODULE 5
Borrowlots Ltd’s net proceeds $39 226 222.46 $39 037 433.16 $39 037 433.16

Effective borrowing rate 6.00% 7.50% 7.50%

When calculating the pay-off for the long cap in dollar terms, the pay-off formula used is
Max [(Cap PV – BBSW PV), 0]. Here, the long cap pay-off is effectively calculated as:

(PV of net proceeds) – (PV of gross proceeds)

The PV of net proceeds uses the cap rate of 7.5 per cent, as this is the effective rate payable by
Borrowlots Ltd given the cap:

PV of net proceeds = $40 000 000/(1 + (0.075 × (120/365))) = $40 000 000/1.024658 =
$39 037 433.16
 324 | INTEREST RATE RISK MANAGEMENT

The PV of gross proceeds uses the BBSW rate of 9.0 per cent, as this is the rate that is payable
under the borrowing (without the cap):

PV of gross proceeds = $40 000 000/(1 + (0.090 × (120/365))) = $40 000 000/1.029589 =
$38 850 452.37

The long cap pay-off is therefore:

$39 037 433.16 – $38 850 452.37 = $186 980.79

Question 5.2
The organisation will transact a Receive Fixed (pay floating) interest rate swap.

The interest rate payments on the swap will be as follows.

Year 1 2 3 4

Pay floating ($7 000 000) ($5 010 000) ($3 030 000) ($1 060 000)

Receive fixed $6 900 000 $6 900 000 $6 900 000 $6 900 000

Net swap payments ($100 000) $1 890 000 $3 870 000 $5 840 000

Question 5.3
The organisation can enter into an interest rate payer swaption under which the market swap
rate will be compared to the swaption rate in two years’ time. If the market swap rate is higher
than the swaption rate (4.00 per cent), the organisation will exercise the swaption by entering
into a swap at 4.00 per cent. If the market swap rate is the same as, or lower than, the swaption
rate, the swaption will lapse and the organisation will enter into a swap at the prevailing market
MODULE 5

swap rate.

The effective borrowing rates will be as follows.

Swap rate < Swap rate = Swap rate >

Swaption rate Swaption rate Swaption rate

Swap rate in two years 3.50% 4.00% 4.50%

Exercise swaption? No No Yes

Pay-off payer swaption 0 0 0.50%

Hedged borrowing rate 3.50% 4.00% 4.00%

 Suggested answers | 325

Question 5.4
Fair value $89 800

Fixed leg
$10 000 000 × 7.00% = $700 000

Date Fixed CF Discount factor PV

30/06/2016 $700 000.00 0.952 $666 400
30/06/2017 $700 000.00 0.898 $628 600
$1 295 000

Floating leg
$10 000 000 × 7.00% = $700 000

$10 000 000 × 8.00% = $800 000

Date Floating CF Discount factor PV

30/06/2016 $700 000.00 0.952 $666 400
30/06/2017 $800 000.00 0.898 $718 400
$1 384 800

$1 384 800 – $1 295 000 = $89 800

Question 5.5
(a) The hedging strategy for the organisation would be to do the following.

Land purchase costs

–– Enter into a two-year payer swaption starting in three months for $75 million to hedge

MODULE 5
the potential property purchase. The swaption rate would be 6.75 per cent and the cost
would be 0.55 per cent.

The results of the tender will be known in three months’ time. So, the organisation would
want a swaption that begins in three months to hedge the $75m purchase costs.

The organisation wants to protect itself for two years (i.e. one year for planning and one year
for building). The organisation wants to protect against rising interest rates, so would like to
pay fixed (i.e. Payer swaption).
 326 | INTEREST RATE RISK MANAGEMENT

This land will eventually be sold at the completion of the construction phase in two years and
three months’ time. The swaption can be entered into immediately, with a start date in three
months’ time (when the tender is announced). It then lasts for two years, which covers us for
the duration of the planning and construction phases.

Development costs
–– Enter into a one-year payer swaption starting in 15 months’ time for $100 million to hedge
the construction project. The swaption rate would be 6.65 per cent and the cost would be
0.65 per cent.

If successful with the tender, the organisation is going to build a $50m resort, or a $100m
complex on the land. Planning would start in 3 months’ time (when the tender is announced),
and approval would be expected to take 12 months. It is only at this point that we know
which construction project will proceed. Construction and sale will then take a further
12 months.

So, the organisation can hedge the potential $50m or $100m construction with a payer
swaption. This can be entered into immediately, to start in 15 months’ time (when planning
approval is received). The organisation would hedge the higher amount of $100m,
which would be sufficient to cover either project. The swaption would last for one year,
being the duration of the construction and selling phase.

Additional information
A swaption can be the preferred derivative when an organisation is unsure that future cash
flows will actually take place. A swaption is the option to enter into a swap. The organisation
is not locked into the swap and is protected against rising rates if a forecast cash flow
actually occurs.

If interest rates fall, the organisation will let the swaption lapse and will benefit from lower
rates. If interest rates rise, the swaption will be exercised, protecting the organisation from
higher rates.
MODULE 5
 Suggested answers | 327

Swaptions and caps would typically achieve the same outcome. However, note that there
are no ‘two-year’ caps starting in 3 months, and there are no ‘one-year’ caps starting in
15 months, so a swaption is preferred in this case.

The following outcomes may eventuate.

Scenario (b) Interest rates > hedged rates (c) Interest rates < hedge rates

In three months’ time (e) Action required (e) Action required

the organisation is Hedge transactions have value, The hedge transactions have no
unsuccessful in property hence sell all swaptions. The value, hence let the swaption
tender. value received from selling the lapse.
swaptions would be used to
offset the cost of the swaptions.

(d) Benefit/(cost) (d) Benefit/(cost)

Two-year payer swaption 1.50% Two-year swaption cost (0.55%)
Less swaption cost (0.55%) $75m over two years (0.55%)
$75m over two years 0.95%
One-year swaption cost (0.65%)
One-year payer swaption 1.50% $100m over one year (0.65%)
Less swaption cost (0.65%)
$100m over one year 0.85%

In three months’ time (e) Action required (e) Action required

the organisation is Property hedge transaction has Property hedge transaction has no
successful in property value, hence exercise the $75 value, hence let the swaption lapse
tender. million swaption. and enter into a two-year swap at
prevailing swap rates.

(d) Benefit/(cost) (d) Benefit/(cost)

Two-year swap 1.50% Two-year swaption cost (0.55%)
Less swaption cost (0.55%) $75m over two years (0.55%)
$75m over two years 0.95%

In a further 12 months’ (e) Action required (e) Action required

time the organisation Construction hedge transaction Construction hedge transaction
receives approval for has value, hence exercise the has no value, hence let the

MODULE 5
apartment complex. $100 million swaption. swaption lapse and enter into
a one-year swap at prevailing
swap rates.

(d) Benefit/(cost) (d) Benefit/(cost)

One-year swap 1.50% One-year swaption cost (0.65%)
Less swaption cost (0.65%) $100m over one year (0.65%)
$100m over one year 0.85%

In a further 12 months’ (e) Action required (e) Action required

time the organisation Construction hedge transaction Construction hedge transaction
receives approvalfor has value, but the organisation for $100 million has no value.
resort. only requires $50 million. Hence, The organisation only requires
exercise the $50 million of the $50 million, hence allow the
swaption and sell the remaining swaption to lapse and enter into a
$50 million (total of $100 million). swap for $50 million at prevailing
swap rates.

(d) Benefit/(cost) (d) Benefit/(cost)

One-year payer swaption 1.50% One-year swaption cost (0.65%)
Less swaption cost (0.65%) $100m over one year (0.65%)
$100m over one year 0.85%
MODULE 5
 References | 329

References
References

Hanke, S. H. & Kwok, A. K. F. 2009, ‘On the measurement of Zimbabwe’s hyperinflation’,

Cato Journal, vol. 29, no. 2, pp. 353–64, accessed May 2010, http://www.cato.org/pubs/journal/
cj29n2/cj29n2-8.pdf.

RBA (Reserve Bank of Australia) 2012, ‘OTC derivatives market reform considerations’, RBA,
March, Canberra.

RBA (Reserve Bank of Australia) 2013a, ‘RBA chart pack—updated regularly for financial market and
other statistics’, accessed September 2013, http://www.rba.gov.au/chart-pack/interest-rates.html.

RBA (Reserve Bank of Australia) 2013b, ‘Statistical tables’, accessed July 2013, http://www.rba.gov.
au/statistics/tables/index.html#content.

MODULE 5
Optional reading
Hull, J. C. 2008, Options, Futures, and Other Derivatives, 7th edn, Prentice Hall, New Jersey.
MODULE 5
 FINANCIAL RISK MANAGEMENT

Module 6
FOREIGN EXCHANGE AND
COMMODITY RISK MANAGEMENT
BRETT DOBESON
 332 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Contents
Preview 333
Introduction
Objectives

Part A: Foreign exchange risk 334

Background to foreign exchange risk management 334
Demystifying foreign exchange 337
Key attributes common to forwards and other financial instruments
Five key elements of foreign exchange
Foreign exchange risk management 343
Step 1: Set the core criteria
Step 2: Identify exposures and sensitivities
Step 3: Appraise risks and implement set strategies
Step 4: Operations—implement strategies
Risk management for importers
Risk management for exporters
Step 5: Accounting and controls

Part B: Commodity risk 377

Introduction 377
Contango and backwardation
Soft commodities 379
Metals 379
Base metals
Bulks
Energy 381
Precious metals 382
The gold market
Recent trends in foreign exchange and commodity risk management

Review 390

Suggested answers 391

References 395
MODULE 6
 Study guide | 333

Module 6:
Foreign exchange
and commodity risk
management
Study guide

Preview
Introduction
This module deals with the identification, measurement and management of foreign exchange (FX)
and commodity exposures. The module is designed to enable a corporate treasurer, risk manager
or financial controller to:
• become familiar with FX and commodity markets and instruments;
• develop a five-stage strategic approach to FX risk management;
• identify the exchange and commodity risk to which an organisation is exposed;
• develop strategies for managing FX and commodity exposures; and
• understand pricing techniques for core FX risk management products. MODULE 6

Objectives
At the end of this module you should be able to:
• explain foreign exchange risk and foreign exchange risk management;
• explain commodity risk and commodity risk management;
• determine the key drivers that impact on currencies and commodity risk management;
• identify and explain the sources of foreign exchange and commodity exposures and sensitivities;
• analyse appropriate risk management strategies that address foreign exchange rate and
commodity exposures; and
• select and apply appropriate hedging instruments to formulate strategies to manage
foreign exchange and commodity exposure.

The first part of this module covers the main features of FX markets and instruments with
applications to managing FX risk. The module then provides an overview of commodity markets,
with a particular focus on gold.
 334 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Part A: Foreign exchange risk

Background to foreign exchange
risk management
Foreign exchange (FX) risk describes the risk of a variation in the exchange rates on an
organisation’s profitability and net value, as measured in the organisation’s functional currency.

Consider the simple economic equation:

Price (P) × Quantity (Q) = Total Cost (TC) or Total Revenue (TR)

For those involved in transactions where there is an international component, the equation
becomes:

P commodity × P currency × Q = TC or TR

Currency prices are notoriously volatile—that is, risky. Figure 6.1 shows the movements in the
AUD/USD exchange rate since the AUD was floated in 1983. The chart shows that between
1982 and 2012 the AUD/USD traded in a range from 1.10 to a low of 0.4775. Over that time,
the AUD has averaged around 72 US cents. Clearly, such volatility can have a major influence
on a company’s profitability and even solvency, and needs to be part of the financial risk
management program.

Figure 6.1: Movements in the AUD/USD exchange rates from 1982–2012

AUD/USD

1.1000

1.0000

0.9000

0.8000

0.7000
MODULE 6

0.6000

0.5000

0.4000
Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 Jan-07 Jan-12

Source: Based on data from Reserve Bank of Australia 2013, ‘Exchange rate data’,
accessed August 2013, http://www.rba.gov.au/statistics/hist-exchange-rates/.
 Study guide | 335

This volatility translates directly into the profitability of organisations. For example, a hypothetical
importer benefits as the AUD strengthens. Figure 6.2 shows a hypothetical organisation’s
sensitivities to the AUD/USD exchange rate. Assume it is an international aid organisation and
that the sensitivity represents the ability of a strong Australian dollar to assist more orphaned
children and the effect of a weak Australian dollar on the same project. At AUD/USD 0.9000 or
above, at least 10 000 children can be assisted. At under AUD/USD 0.7000 that number falls to
approximately 8000 children.

The implications are that when the Australian dollar is strong the organisation can offer more
aid packages and perhaps, using outright forward exchange rates, lock in this ability for future
years. In itself, the exchange rate is just a figure. The left hand axis is not in itself of importance.
However, when translated into corporate language, in this case, the number of children that can
be assisted, the significance is apparent.

Figure 6.2: Currency levels and implications for an aid organisation:

AUD 10 million income stream

AUD/USD Aid level

1.1000 12 000

1.0000 11 000

0.9000 10 000

0.8000 9 000

0.7000 8 000

0.6000 7 000

0.5000 6 000

0.4000 5 000 MODULE 6

Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 Jan-07 Jan-12

Source: Based on data from Reserve Bank of Australia 2013, ‘Exchange rate data’,
accessed August 2013, http://www.rba.gov.au/statistics/hist-exchange-rates/.

Note that the sensitivities would include those derived from embedded options. In the case
of the above example, perhaps offsetting exchange rate falls with increases in aid-in-kind,
such as wheat and rice, could be undertaken. These commodities actually benefit from a weaker
Australian dollar as they are sold in the strengthening USD.

An organisation’s sensitivity to exchange rate movements can be an important issue for its
overall profitability or its ability to meet its objectives (such as the provision of aid to children).
 336 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Australian chief executive officers (CEOs) also have obligations under the Corporations Act
2001 (Cwlth) and ASX listing requirements, as well as the need to conform to international and
Australian accounting standards that require the identification and quantification of all derivatives,
including options embedded in capital expenditure, trade and other contracts. American CEOs
can be jailed for up to 20 years for failing to adequately identify financial exposures, of which FX is
often a major component.

Currency wars and commodity-based currencies

Consider the concept of a currency war introduced in Module 1. Currency wars are best
understood as the process by which sovereign nations seek to devalue their currency against
others to gain a competitive advantage. The process, sometimes referred to as competitive
devaluation, seeks to reduce the real price of export, through reductions in exchange rates.
The impact of a currency war on the domestic economy of a given country is essentially that
the cost of imports increases, while export prices decrease, stimulating local economic activity.
However, where this is done through loose monetary policy, the country runs the risk of creating
inflation and debasing its currency. In the long run, however, retaliatory actions by other countries
may result in a detrimental impact on all countries through reduced global trade flows.

Where monetary policy is implemented inaptly, currency performance can be affected

dramatically. The response of central banks to inflation risk is equally critical to the performance
of a currency. Where a currency peg or fixed rate regime is in operation, adjustments to the
cash rate have no material impact on the currency position because of the offsetting actions of
the central bank. Where a floating rate regime is in operation, the implementation of monetary
policy, and in particular the differences between yields available on different currencies as a result
of changes in monetary policy, can bring about an appreciation or devaluation of one currency
relative to another.

Holding other factors constant, an increase in the domestic interest rate is assumed to increase
the return associated with a domestic interest-bearing asset relative to a foreign alternative.
This in turn results in upward pressure being applied to the exchange rate, though it is pertinent
to note that the association is not linear nor constant, but rather it has been the most observed
tendency. As such, it can be asserted that an increase in interest rates, a common mechanism
adopted to moderate inflation risk, increases the yields on domestic interest bearing assets and
consequently encourages higher exchange rates. Consequently, inapt or poorly considered
monetary policy can give rise to unintended consequences for exchange rates.

Beyond monetary policy, a number of other factors can influence the performance of a particular
currency. The expression ‘commodity currency’ is frequently used to describe a currency that is
significantly influenced by a commodity or commodities. While the term is synonymous with a
number of emerging countries, a number of developed countries are also frequently referred
MODULE 6

to as commodity currencies. The Australian, New Zealand and Canadian currencies are often
described in such terms. The Australian dollar has historically exhibited a strong and positive
correlation with the gold price, in excess of 80 per cent between 2000 and 2008. Australia is
a major exporter of a number of other key mineral and agricultural resources and therefore it
should come as no surprise that global commodities prices are strongly associated with the value
of the currency. The association can be described simply—as demand for commodities increases,
so too does demand for the Australian dollar needed to acquire the commodities, resulting in a
relative increase in the value of the currency against alternatives such as the EUR, USD and GBP.
Nonetheless, it is pertinent to note that the association is not perfectly linear, nor is it constant,
but rather it is the association that has been observed in practice for some time. However,
a number of factors are relevant to the value of a currency beyond commodities, such as
inflationary pressures, interest rates and economic growth.
 Study guide | 337

A point to note is that if a company’s functional currency is a commodity-based currency, there is

potentially greater complexity associated with formulating viable hedging strategies. Where a
company is exposed to both currency and commodity risk, effectiveness testing of any hedging
strategy is arguably more complex than with any risk exposure in isolation.

Demystifying foreign exchange

Key attributes common to forwards and other financial
instruments
The points below set out attributes common to all the financial instruments to be discussed—
swaps, options, futures and capital market products.

At the time they are initially priced, net of bank margins:

1. their net present value (NPV) is zero;
2. there is no forecasting involved in the setting of the prices/rates;
3. the bank is not guessing at or speculating on future movements in exchange rates; and
4. the only difference in the pricing of options, swaps, forwards and futures relates to the
characteristics of each instrument—there is a different mix of risk + return + timing of cash
flows involved.

To say a certain product is ‘too expensive’ implies either that a risk manager does not trust
that the market price is correct (which is improbable) or that there are excessive margins and
fees involved (much more likely, but checkable). To reiterate an important point, banks are
conservative. When pricing products for their clients they do not have to forecast future rates—
forward rates do not involve forecasts.

Financial instruments are a means to an end. From the viewpoint of an organisation, their role is
as shown in Table 6.1.

Table 6.1: Strategic use of foreign exchange financial instruments

Goal Instrument/market Comments

1. Purchase or sell currency Spot market Operates like any other purchase/sale
of a commodity

2. Lock in a known future FX Forwards and Adjusts extent of exposure to exchange rate
AUD value futures movements MODULE 6
3. Adjust timing of cash flows FX Swaps Provides the ability to change the timing of
and/or currencies cash flows

4. Manage the risk/return FX Options Type of insurance

trade-off

5. Financial engineering Combinations of [1] Any combination of risk/return trade‑off and

to [4] cash flow management is possible—at a price
 338 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Five key elements of foreign exchange

1. The spot price
The Australian dollar is a commodity just like any other, and it is being bought and sold for
money—US dollars (AUD/USD), yen (AUD/JPY) or any other pairing of two commodities.

FX rates are quoted in the following way:

AUD/USD 0.9000

This means that one Australian dollar can be bought or sold for 90 US cents.

Table 6.2 shows the effect a one-point (known as a ‘basis point’) change in the AUD/USD rate has
on Australian dollar cash flows. For example, at AUD/USD 0.7000, a one-point movement to AUD/
USD 0.7001 will result in a net change of AUD 204 per USD 1 million, while at AUD/USD 0.6000, a
one-point movement will result in a net change of AUD 278 per USD 1 million.

Table 6.2: Sensitivity of AUD cash flows to exchange rate changes

AUD/USD exchange rate Point change in value per USD 1 million

1.0000 AUD 100

0.9000 AUD 123

0.8000 AUD 156

0.7000 AUD 204

0.6000* AUD 278

0.5000 AUD 400

* USD 1 million at 0.6000 = AUD 1 666 667

USD 1 million at 0.6001 = AUD 1 666 389
Difference = AUD 278

2. Two-way prices
Sometimes the quotation of the spot rate has two prices rather than one. For example:

AUD/USD 0.9000 – 0.9055

This is like prices used by wholesale traders at, for example, the fish market, where they both
MODULE 6

buy and sell fish. The currency dealer is showing both the price for buying Australian dollars
(USD 0.9000 or 90.00 US cents) and the price at which the dealer will sell Australian dollars
(USD 0.9055 or 90.55 US cents). FX dealers work on the same basis as every other trader:
‘Buy low, sell high’. Note that such quotations are often shortened to AUD/USD 0.9000 / 55
(i.e. the 90 US cents selling price is implied).

A frequently asked question is: ‘Are you receiving retail or wholesale FX rates’?

You can tell by looking at the spread—the difference between the two rates. In the present
case the rate is quoted as:
AUD/USD 0.9000 – 0.9055.
The spread is 0.0055 or, in market parlance, 55 ‘points’.
This is a retail business rate because the spread is quite large. Nevertheless, if you consider
consumer retail rates displayed at banks, the spread on cash conversion can be closer to
900 points—so it pays to shop around for the institution that offers the best spreads for the size
of transaction that you plan to execute.
 Study guide | 339

Wholesale rates generally have spreads of less than five points for most major currencies. In this
case, a wholesale or interbank rate would be something like:
AUD/USD 0.9025 – 0.9030.
The spread is 0.0005 or, in market parlance, 5 ‘points’.

Wholesale rates are normally only available if you deal in reasonably large amounts, such as
$5 million or above, as the market convention for an inter-bank transaction size, or parcel size is
typically AUD 10 million.

Quotation conventions
The market convention is to quote all currencies against the US dollar (USD). There are two
different ways of quoting spot exchange rates: direct quotes and indirect quotes. Global market
convention determines whether a quote is direct or indirect.

Direct quote
In a direct quote, the currency being bought or sold (i.e. the base or commodity currency) is the
USD. The other currency in the quote is known as the terms currency.

For example, consider the following spot quotes against the USD:
1. USD/JPY 120.00
2. USD/SGD 1.3000

USD/JPY 120.00

Base currency Terms currency

In (1), the USD is being bought or sold against the Japanese yen (JPY), and USD 1 is worth
JPY 120.00. So, as the USD is the commodity being priced, the USD amount remains fixed while
the amount of yen that it will buy or sell changes. For example, if the USD/JPY rate of 120.00
changes to 118.00, this means that the USD has depreciated because it now buys fewer yen
than before. Alternatively, the yen has appreciated against the USD from 1 / 120.00 = 0.00833
to 1 / 118.00 = 0.00847.

In (2), the USD is again the base or commodity currency, but this time it is being quoted
(bought and sold) against the Singapore dollar (SGD). A change in the USD/SGD rate from
1.3000 to 1.4000 means that USD 1 now buys more SGDs; that is, the USD has appreciated
against the SGD.
MODULE 6

Indirect quote
In an indirect quote, the currency being bought or sold (the base currency) is a currency other
than the USD.

The major currencies quoted indirectly are the old sterling based currencies which were originally
quoted this way because of the non-decimal nature of the pound sterling. The introduction of
the euro, which is quoted in the indirect format, was the first non Commonwealth currency to be
quoted this way.

The main currencies quoted indirectly are as follows:

Australian dollar: AUD/USD 0.8500 (AUD 1 = USD 0.85)

New Zealand dollar: NZD/USD 0.8000 (NZD 1 = USD 0.80)
Pound sterling: GBP/USD 1.6300 (£1 = USD 1.63)
Euro: EUR/USD 1.2800 (€1 = USD 1.28)
 340 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

➤➤Question 6.1
An importer needs to buy USD 1 million to pay for goods.
The rate quoted by the bank is AUD/USD rate 0.9450 / 70.
(a) At which rate will the company deal with the bank to buy USD?
(b) What will the cost be in AUD?

3. Forward rates
The forward exchange rate is an outright rate that an organisation can lock in today for
settlement at a future date. It is very likely to be different from the spot rate at the time of
settlement (delivery). If it were the same, it would be because the interest rate differential
between the two currencies was zero over the time period.

Forwards and futures allow organisations to remove or modify exposures to future exchange-
rate movements and therefore to fix the Australian dollar value of sales, purchases and/or capital
transactions. If full cover is taken, dangers and opportunities from subsequent movements in
currencies are eliminated.

To calculate the forward rate you need only know the time before the exchange is to be made
and the local interest rates in the two countries. The wider the margin between these interest
rates, the more the forward exchange rate will differ from the spot rate. At the time of the actual
transaction, the net present value of the forward should be the spot rate—and the future value of
the spot rate will be the forward rate.

Forward rates are not forecast rates

Forward rates, also known as outright rates, do not involve forecasts of the future spot rate.
They are determined purely by current interest rates in the two countries concerned. They are
simply a combination of the spot exchange rate and two interest rates.

Example: AUD/JPY: Since Japan’s one-year interest rate is around 1 per cent and Australia’s
about 5 per cent, the forward rates are favourable to Australian exporters.

Calculation: Spot rate × (1 + Japanese interest rate) / (1 + Australian interest rate) = Forward rate.

This adds around AUD 40 000 profit per AUD 1 million for exports (or costs for imports),
assuming the above figures.

Exchange rate determination is an issue which has been extensively studied and discussed by
MODULE 6

investors, government officials, academics and traders, yet there is still no definitive method
of predicting currency movements. No single approach provides a satisfactory explanation
of currency rate movements, particularly short-term movements. Ultimately, in a floating-rate
regime, the interaction of supply and demand factors for two currencies in the market is the key
determinant of the rate at which currencies trade. Factors which can influence the supply of or
demand for a currency and, hence, the exchange rate include:
• inflation;
• balance of payments;
• monetary policy;
• interest rates;
• political factors;
• economic indicators; and
• market sentiment.

Exchange rates are influenced by these and other economic and political forces.
 Study guide | 341

In a speech to the 21st Annual Monetary Conference in Washington in 2003, then US Federal
Reserve Chairman Alan Greenspan said:
My experience is that exchange markets have become so efficient that virtually all relevant
information is embedded almost instantaneously in exchange rates to the point that anticipating
movements in major currencies is rarely possible. Despite extensive efforts on the part of analysts,
to my knowledge, no model projecting directional movements in exchange rates is significantly
superior to tossing a coin (Greenspan 2003).

Given the unpredictable nature of currency movements, organisations should not rely on currency
forecasts when making risk management decisions. FX decisions should be made in accordance
with the risk management framework outlined in this module.

➤➤Question 6.2
ABC Bank has just issued its forecasts and expects the Reserve Bank of Australia to increase
interest rates substantially next month and the AUD to rise.
Explain the financial risk management concepts relevant to ABC Bank’s outlook.

4. Swaps—managing timing and/or currency mismatches

Swaps were explained in detail in Module 4. They enable cash flows and currencies to be moved
around, in turn enabling offsets and cash flows to be used to adjust an organisation’s risk exposure.
For foreign exchange, a swap involves the simultaneous buying (selling) of a certain amount of
currency on a particular date (usually the spot date) and doing a reverse transaction (i.e. selling
(buying)) the same amount of currency on a future date.

Example 6.1: Removing a timing mismatch

In this example, the organisation does not actually have a currency exposure—only a timing mismatch
since total US dollar cash flows net to zero.

March receives USD 10 million

June pays USD 5 million

September pays USD 20 million

December receives USD 15 million

Total net USD position NIL

The organisation could use swaps to transfer three of the transactions into the month of the remaining
MODULE 6

transaction. If the organisation wanted to remove all foreign currency exposure by June it could take
the following actions.

1. Use an FX swap to move the March USD 10 million receipt into June. To do this, the organisation
would need to sell USD 10 million (buy AUD) in March and simultaneously buy USD 10 million
(sell AUD) back in June. The AUD amount received in March could be invested until required
in June.

2. Use an FX swap to move the September payment of USD 20 million into June. To do this,
the organisation would sell USD 20 million (buy AUD) in June and buy USD 20 million (sell AUD)
in September before making the USD payment.
 342 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

3. Use an FX swap to move the December receipt of USD 15 million into June. To do this,
the organisation would buy USD 15 million (sell AUD) in June and sell USD 15 million (buy AUD)
in December. On receipt of the USD 15 million in December, the organisation would use the funds
to settle the FX transaction.

The net amount paid/received in June is therefore USD 0. However, the organisation would have some
AUD interest receipts/payments, leaving a small net residual.

5. Options
Options work the same way as insurance policies. In fact, an insurance policy is one type of
option contract: you pay a premium and get a financial return if a certain event occurs. You simply
nominate the exchange-rate level at which you want protection, along with the date. The bank
then charges you a premium for providing the required protection. As with insurance policies,
options can be tailored to your requirements.

Options come in two types, which you can either buy or sell.

Puts These give you the right to sell something, such as US dollars, at a specific price.
Calls These give you the right to buy something, such as US dollars, at a specific price.

Normally, options are marketed by what they do, such as ceilings (caps) or floors. The other
common option is a nil-premium collar which is just a combination of a cap and a floor, which gives
you a range. For example, if you are an exporter to Japan, you could buy an AUD call/JPY put as
a ceiling (cap) with no worse a rate than AUD/JPY 86. You would also sell an AUD put/JPY call at a
rate of AUD/JPY 80 to set a no-better-than rate or floor. These two options would create a range of
exchange rates between AUD/JPY 80 and 86 for your JPY income to be converted to AUD. The nil
premium means that there is no cash premium for this as the value of the bought option and the
sold option are offset. This is similar in concept to an insurance policy with an excess clause.

Pricing options
Because there is a widespread belief among organisations that options are too expensive, it may
be worth briefly outlining how they are priced.

Options require the following inputs:

1. Exchange rate at which protection is required (set by the organisation).
2. Date or length of time over which protection is required (also set by the organisation).
3. Interest rates in both countries involved—for example, Australian and US rates (set by the
market and readily available).
4. The current exchange rate (as for (3)).
5. Volatility, or risk (probability) that the option will be exercised (also able to be bought
MODULE 6

and sold in financial markets, although not normally published in the non‑financial
daily newspapers).

Standard formulas are then used to calculate a fair price. As with all other instruments,
minus bank margins, the NPV of an option when initially priced should be zero.

Options are an excellent way to allow an organisation to benefit from favourable exchange-rate
movements but protect it against adverse movements. Embedded options, such as repricing
clauses, also need to be quantified and managed, as they have exactly the same effect on the
commercial outcome of an organisation’s activities. Often they are mispriced—either cheaper
or more expensive—than those available from financial institutions, which is why it is crucial to
implement the organisation’s financial risk management program before negotiating contracts.
 Study guide | 343

Failure to identify and quantify embedded options has led many organisations to make serious
errors of judgment. This includes the famous AWA case, where directors swore on oath that
their exposures were around AUD 200 million, while in fact the existence of embedded options
put their actual exposures as low as AUD 40 million. The board was not informed of this and
presumably the senior managers of AWA failed to read their contracts. Refer to Reading 1.1 for
full details of the AWA case.

Implications
The financial clauses of contracts often contain crucial elements, whether they are for normal
purchases and sales, funding or insurance. Directors need to be aware of this and should request
at least an annual audit of these clauses and their impact on the organisation’s overall exposures.

Financial engineering
Almost every other product an organisation is offered in the financial markets is simply a
combination of spot, forward and option products. However, there are endless different
names for products that are essentially the same. For example, a collar (see the introduction
to ‘Options’) is also known as a nil-premium collar, bracket, zipper, range forward, tramline and
parallel forward. They are just different proprietary brands. It is very similar to the difference
between generic brands, such as baked beans or aspirins: same product, different labels and
marketing strategies.

Foreign exchange risk management

At a forum on FX held by the Australian Institute of Company Directors, Professor Don Harding
emphasised the necessity for company boards of directors to understand FX exposure
management. Drawing on the judgment relating to the case of Commonwealth Bank of
Australia v. Friedrich (1991) 5 ACSR 115, Harding (2004) stated that:
A director cannot plead that he/she had no skill at understanding the financial affairs and
accounts—it is of the ‘essence’ of the responsibility of directors in guiding and monitoring
management that they inform themselves that the accounts and financial affairs of the company
are accurate and under control.

Directors cannot plead ignorance. Therefore they need to ensure that the organisations they
govern fully understand financial risk management.

The process of effective financial risk management involves the key steps first introduced in
Module 1 (see Figure 1.18, which has been adapted as Figure 6.3 for the specific purpose
MODULE 6
of FX exposure risk management). The adapted steps are as follows.
1. Set the core criteria.
2. Identify exposures and sensitivities.
3. Appraise risks and set strategies.
4. Operations: Implement strategies.
5. Accounting and controls.

Consistent with the interest-rate risk management module, this methodology will be applied
to the current issues of financial risk exposure management.
 344 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Figure 6.3: The foreign exchange risk management process

1. Set the core criteria

Profit
Local currency
Margins
Industry currency Functional Benchmarks
Cash flow
Parent currency
NPV
2. Identify exposures
and sensitivities

Embedded options Currency clauses Offsets Internal

• repricing clauses • base currency • netting • intra-company
• ceiling/floor agreements • alternative markets • matching • inter-company
• guarantees • triggers • portfolio
• warranties • funding
• leading/lagging

3. Appraise risks and implement

set strategies

Proactive Mitigation Insurance

• project management • benchmarking • EFIC
• windows of opportunities • hedging • financial market insurance
• value migration • financial engineering • other insurance

4. Operations:
Implement strategies

Forwards Swaps Capital markets Futures Options Hybrids

5. Accounting and controls

Step 1: Set the core criteria

The first step is to put FX exposure management in the context of the organisation’s key
MODULE 6

strategies and benchmarks.

The key issues identified in Figure 6.3 are to determine the functional currency and to set the
benchmarks or business objectives. These are covered in turn.

Functional currency
Under accounting standards, a board resolution is required that states the organisation’s functional
currency (as outlined under IAS 39, which is explained at length in Module 7). For example,
British Petroleum (BP) made a formal board resolution that its functional currency is the US dollar.
BP argues that because it is an oil company and oil is a US dollar-based commodity, BP is effectively
US dollar-based—in spite of the fact that the organisation reports in pounds sterling and its largest
proportion of shareholders are British.
 Study guide | 345

The result is as follows:

• functional currency: USD
• reporting currency: GBP (Sterling)

Therefore transactions denominated in USD would not result in FX risk to BP despite its reporting
in GBP.

Unfortunately, many organisations ignore the requirement to identify their functional currency.
For example, in Australia few exporters have formal board resolutions stating their functional
currency. As a result, shareholders are unsure as to whether they have a local currency exposure
or an international one.

Business drivers
Some boards will be keen to adopt an aggressive approach to FX management while others will
opt for a far more defensive strategy. The trade-off between risk and expected return is a choice
each organisation needs to make for itself, but it sets the background for the remainder of the
risk management program.

Business drivers include revenue and/or cost targets, return on assets or equity, cash flows,
financial ratios, such as working capital ratios, and other key indicators, such as NPV.

The board must also specifically resolve whether treasury is to be treated as a profit centre or
business unit, or whether it will act as a corporate financial intermediary or cost centre. It is rare
that corporate treasuries are set up specifically as profit centres (AWA was one example), but in
FX there may be opportunities for benefiting from the volatility in currency markets to take
advantage of international market imbalances.

Key strategic objectives

Corporate financial risk management is a means to an end rather than an end in itself.
Therefore FX risk management must always be undertaken with an organisation’s key strategic
objectives in mind.

Often the organisation’s three- or five-year plan can be the basis of the establishment of a
complementary currency strategy, including the setting of key exchange-rate levels that would
trigger both opportunities and dangers for the business operations. In other words, organisations
need to establish both materiality thresholds and other key trigger levels prior to entering
the operational phase of their business. Without these, they risk being benchmarked against
hindsight, which would place management in a no-win position.
MODULE 6

Step 2: Identify exposures and sensitivities

Exposures to foreign exchange
FX and commodity exposures can be committed or uncommitted. This is an important
determinant of how risk should be managed and when risk management should be undertaken.
Commodity exposures can be particularly uncertain because of possible extraction delays and
variations in the quality of the raw materials.

Committed exposures
Committed exposures are defined as contracted exposures. These include sale or purchase
contracts in a foreign currency and other committed foreign currency, cash flows such as royalty
payments or interest payments on foreign currency loans.
 346 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Uncommitted exposures
Uncommitted exposures are expected but uncontracted exposures. They are potential transactions
which can be anticipated as part of the firm’s business such as forecasted sales or purchases that
are likely to be made in a foreign currency. For example, a coal producer may know that it has
50 000 tonnes stockpiled and available for export but has not yet finalised any sales contract.
However, it may wish to take advantage of a strong US dollar by locking in part of the probable
exposure (the exposure to exchange rate movements), thereby giving the company more flexibility
in negotiating on the price of the coal itself.

The ideal instruments for probable rather than actual exposures are purchased options, for they
confer the right but not the obligation to deliver on the contract (refer to the section on forward
exchange contracts (FECs) and options).

There are four main areas for exposures to FX:

1. Contracts. These can be priced in foreign currencies, involve exports and imports, or include
embedded options through such arrangements as repricing clauses, or allow for profit
opportunities via movements in exchange rates.
2. Capital and equity markets. Offshore borrowings, investments or subsidiaries.
3. Internal organisation offsets. Such as imports from one business unit to be offset against
export earnings from another business unit.
4. Secondary positions in financial markets and instruments. Forwards, futures, swaps,
options and other derivatives used to adjust initial exposures or to take proprietary
(speculative) positions.

Exposures to currencies include both stocks (offshore assets, borrowings) and flows (revenue and
cost streams, debt servicing). There are also primary exposures arising from the underlying business
operations and secondary exposures, normally a result of hedging the primary exposures—
such as borrowing US dollars to hedge against US dollar revenues from export earnings. However,
the impact of accounting requirements has reduced the frequency of using borrowings to offset
income-generated cash flows. Accounting issues can unfortunately outweigh the underlying
business imperatives.

FX risk is often categorised under the following headings.

Transaction exposure
This is the exposure that arises when an organisation is either paying or receiving foreign
currency and needs to convert it back to its functional currency. An example would be an Australian
exporter which sells goods and receives payment in USD. Subcategories are listed below:

Transaction risk—OPEX and Revenue: Resulting from contracts/commitments for the supply
MODULE 6

of goods and services where payment is denominated in foreign currency and the underlying
exposure item is reported in the profit and loss statement.

Transaction risk—CAPEX: Resulting from contracts/commitments for the supply of goods and
services where payment is denominated in foreign currency and the underlying exposure is
reported in the balance sheet.

Those USD need to be sold in exchange for AUD. As the exchange rate moves, the amount of
AUD received will vary. This exposure will affect cash flows and the income statement or balance
sheet (e.g. hedging capital purchases and the hedge result is included in the cost of the asset
(i.e. basis adjust method in IAS 39)). Also, for cash flow hedges there are impacts that can affect
the balance sheet.
 Study guide | 347

Translation exposure
Translation exposure arises when a company has an asset or liability in a different currency.
The value of this asset or liability will need to be converted back to the functional currency for
inclusion in the financial statements. This exposure will affect the balance sheet, as will results
from accounting exposures arising from the translation of investments denominated in foreign
currency to the functional currency (which occurs on consolidation).

Competitive exposure
This exposure arises when a competitor sources its goods from a different country. An example
would be an Australian organisation manufacturing and selling cars in Australia, with all
its expenses in AUD. An overseas car maker may bring cars into Australia in competition,
for example, from Korea. The price at which the Korean firm sells its cars in Australia will depend
partially on the exchange rate between the AUD and the Korean won. When the AUD is strong
against the won, the Korean car maker will be prepared to sell its cars at a cheaper AUD price,
as it will still provide the company with the amount of Korean won it requires. The Australian
car maker will need to reduce the price of its cars or be prepared to lose market share.
The Australian firm is therefore affected by the Korean won exchange rate in this competitive
exposure sense, although it has no direct exposure.

Economic exposure
Economic exposure is generally taken to mean an exposure that is known but not yet quantified.
An example would be an Australian copper mining company which has a 20‑year mine life.
The company knows that it will be getting the copper from the mine and selling it in USD
(copper, like most commodities, trades globally in USD). At this point, it may not know exactly
how much copper will be extracted, when it will be sold or how much it will receive for the
copper. Therefore, while knowing it has an exposure to USD, the amount is not yet quantifiable
and, hence, it is known as an economic exposure.

Economic accounting exposure

Some Australian organisations also need to look at the accounting implications of aggregate or
net exposures. While something may result in nil net exposures, there could still be volatility to
net profit, profit and loss line items or the balance sheet, depending on the accounting treatment
and the hedge accounting requirements. While we may have economic risk offsets which
offset on a total net basis without hedging, and on a net basis the position is neutral, it does
not necessarily result in a neutral position of individual lines in the profit and loss due to the
accounting treatments for different financial instruments. For example, an organisation may have
a USD loan payable and a USD loan receivable which will give rise to FX exposure from revaluing
the loans. The revaluation of both the loan receivable and loan payable will result in an economic
MODULE 6
offset. However, the accounting treatments may be different for each—the loan receivable may
form part of a net investment in foreign operations, in which case the gains or losses will be
reported in equity on a consolidated basis. The gains/losses from revaluation of the loan payable
will go to the profit and loss. In this case, while there is an economic offset, the profit and loss is
still vulnerable to FX volatility.

Similarly, with hedging there may be an economic offset on a total net basis at maturity (realisation
of exposure). In reality, the accounting of derivative instruments may result in volatility through the
mark-to-market of the transactions and the accounting rules for recognition of these ‘gains/losses’.
While the hedges are economically perfectly effective, the accounting treatments may generate
significant revaluation volatility in both the profit and loss and equity over the life of the instrument.
These gains/losses can significantly affect net profit and gearing.
 348 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

The volatility generated in the profit and loss can cause some confusion to readers of financial
statements where it is the entity’s intention to hold the instrument to maturity. In these
circumstances, the inter-period volatility needs to be put into context—that is, gains/losses
will wind down to nil at maturity and will never be realised. Adequate disclosures should be
made for internal and external reporting, particularly where it is not the entity’s intention to
realise these gains and losses prior to maturity.

Pay-off profiles
With respect to transaction exposures, it is useful to provide tables and/or graphs which
outline the basic relationship between costs and revenues and the movement in exchange rates.
These representations normally assume no initial offsets, such as repricing clauses (which are
added at a later stage).

Figure 6.4 illustrates the opening exposure for a hypothetical importer or offshore borrower.

Figure 6.4: Pay-off profile for importer or offshore borrower

AUD per USD 1 million

Millions

0.80

0.90

1.00

0.7000 0.8000 0.9000 1.0000 1.1000

1.10
Exchange
rate
(AUD/USD) 1.20

1.30

1.40

1.50
MODULE 6

Figure 6.4 shows how a change in the AUD/USD rate affects an importer (or offshore borrower)
which has an exposure to USD and is concerned that the AUD may depreciate, or the USD may
appreciate. Suppose the importer has placed an order for equipment worth USD 1 million and the
current spot exchange rate is AUD/USD 0.9000. The importer’s AUD cost is as follows:

1 000 000 / 0.9000 = AUD 1 111 111.11

If the AUD/USD exchange rate falls to 0.7000, the importer’s cost will rise to:

1 000 000 / 0.7000 = AUD 1 428 571.43

The difference represents a loss to the importer of AUD 317 460.32.

 Study guide | 349

The opposite situation holds for an exporter (or offshore lender) which has an exposure to
USD and is concerned that the USD may depreciate or the AUD may appreciate. This case is
illustrated in Figure 6.5 where, instead of the total amounts, the gain or loss from the change in
exchange rate is graphed.

Figure 6.5: Pay-off profile for exporter or offshore lender

Gain/Loss
(Change in AUD value of USD 1 million per 100-point movement in AUD/USD)

AUD per USD 1 million

30 000.00 Gain

20 000.00

10 000.00
Exchange
rate
(AUD/USD)
0.00
0.880 0.890 0.900 0.910 0.920

–10 000.00

–20 000.00

–30 000.00 Loss

For example, for a USD 1 million export order at an exchange rate of 0.9000, the value
of the order is:

1 000 000 / 0.9000 = AUD 1 111 111.11

If the exchange rate moves to 0.8900, the AUD value of the order rises to:

1 000 000 / 0.8900 = AUD 1 123 595.51 MODULE 6

The difference represents a gain to the exporter of AUD 12 484.40.

➤➤Question 6.3
An Australian company has raised funds in USD. It needs to bring those funds back to Australia
but it will then be paying USD interest annually for five years, at which time the loan will need
to be repaid. What exposures will this loan create both now and in the future?
 350 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Apparent versus actual exposures

The four key issues identified in Figure 6.3 with respect to the identification of apparent
exposures that need to be addressed now are as follows.
1. Internal offsets.
2. Embedded options.
3. Timing mismatches.
4. Commercial adjustments.

These are covered in turn.

Internal offsets
There are both benefits and threats in organisations looking at aggregate or net exposures
rather than managing specific exposures. For example, an organisation with a business unit that
specialises in exporting computers may also have another business unit that imports textiles.
When aggregated there is a small net currency position, which management initially identifies
as insignificant.

However, assume the AUD then surges by 20 per cent. The export arm now faces extreme
competition but, because it has taken no direct cover, suffers a major loss of market share.
The textile import business should provide offsetting increases in sales, but unfortunately,
it had already pre-purchased material for the major Christmas market and is unable to provide
the desired offset. As each business unit is competing in very different markets, the ‘portfolio’
approach failed to provide the expected protection.

Nonetheless, internal offsets can be of great value and need to be considered in all strategic and
operational planning.

Embedded options
Organisations need to examine all trade and capital market-based contracts for embedded
options and determine how they affect actual exposures.

Virtually any financial derivatives (e.g. forwards, options) can be replicated in commercial
contracts and in about half the cases will be superior to using a financial instrument. A simple
example follows.

Example 6.2: Exportalot

Exportalot Ltd (Exportalot) has a USD 20 million exposure one year from today. The company is
MODULE 6

approached by its counterparty to this contract and offered a repricing clause which shares future
movements in the currency on a 50:50 basis. Exportalot was intending to cover 50 per cent of its
exposures anyway, so decided to analyse the offer. The spot rate is AUD/USD 0.9000 and the forward
outright rate is AUD/USD 0.8500. Should Exportalot accept or reject this offer?

Exportalot should reject the offer from its counterparty and simply lock in the forward rate of
AUD/USD 0.8500. This is explained below:

For Exportalot, export prices are in USD. As such, a lower AUD (i.e. 0.8500 instead of 0.9000) leads to
higher AUD revenues. Exportalot would therefore want a lower exchange rate.

If Exportalot covers 50 per cent of its exposure on the financial markets, it locks in USD 10 000 000 /
0.8500 = AUD 11 764 706. This would represent the base case scenario for Exportalot. This compares
to the spot rate conversion of USD 10 000 000 / 0.9000 = AUD 11 111 111, a difference of AUD 653 595.
 Study guide | 351

If Exportalot decided to share future movements in the currency with its initial counterparty, it would
already be AUD 653 595 ‘behind’. By sharing rate movements, the risk to Exportalot is that the AUD
strengthens, or doesn’t depreciate by as much as it could lock in with the forward rate.

Given these risks, Exportalot would not want to give up the benefit it can achieve by locking in the lower
forward rate. It should therefore reject the offer from its counterparty and simply hedge 50 per cent of
the exposure in the financial markets, locking in an exchange rate of 0.8500.

Timing mismatches
It is important to distinguish between currency mismatches and purely timing mismatches,
or gapping exposures. These were introduced in Module 5 in the discussion on ‘The management
of timing mismatches’. Timing exposures can be managed through the use of currency swaps
and also the operation of foreign currency accounts.

Commercial adjustments
Commercial adjustments cover a range of possible issues, chief amongst which is competitor
behaviour in response to currency adjustments. Basically, can costs be passed on?

Sometimes this action can neutralise exposures, such as petrol retailers adjusting all prices to
ensure that it is the end-user who is effectively exposed to currency fluctuations rather than the
organisation’s shareholders. In other industries currency fluctuations may be used to gain market
share or shave margins.

Again, it is important that the risk manager liaise with the business units to ensure secondary
currency risk management is targeting the correct, adjusted currency exposures.

Step 3: Appraise risks and implement set strategies

Measuring adjusted exposures to foreign exchange
Once all the occurrences of currency and commodity risks have been identified, the next step is
to measure the scale and magnitude of the exposures. This process will recognise which of the
exposures are significant and which are likely to affect the profitability of the organisation.

There are various methodologies which a firm may adopt to measure the impact of currency
and commodity exposures. The measurement techniques most used by companies include
sensitivity analysis and cash flow at risk. Sensitivity analysis calculates the effect on earnings
due to changes in market variables (e.g. the calculation of the impact of movements in FX rates).
The same analysis can be conducted for commodity price and interest rate movements. MODULE 6

Example 6.3: Sensitivity

An Australian-based company has revenue of AUD 10 million and costs of AUD 5 million and
USD 3 million. Its target profit margin is 10 per cent. The following analysis shows that at the current
exchange rate of AUD/USD 0.9000, the profit margin is AUD 1.67 million or 17 per cent. A decline in
the AUD/USD exchange rate to AUD/USD 0.7500 results in the profit margin declining to the company’s
target of 10 per cent. Below AUD/USD 0.6000, the company is making a loss unless it can increase
revenue or cut costs.
 352 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

FX sensitivity analysis

Foreign exchange sensitivity analysis

USD costs
AUD/ converted AUD profit AUD profit
AUD sales AUD costs USD costs USD to AUD margin margin %

10 000 000 –5 000 000 –3 000 000 0.45 –6 666 667 –1 666 667 –17

10 000 000 –5 000 000 –3 000 000 0.50 –6 000 000 –1 000 000 –10

10 000 000 –5 000 000 –3 000 000 0.55 –5 454 545 –454 545 –5

10 000 000 –5 000 000 –3 000 000 0.60 –5 000 000 0 0

10 000 000 –5 000 000 –3 000 000 0.65 –4 615 385 384 615 4

10 000 000 –5 000 000 –3 000 000 0.70 –4 285 714 714 286 7

10 000 000 –5 000 000 –3 000 000 0.75 –4 000 000 1 000 000 10

10 000 000 –5 000 000 –3 000 000 0.80 –3 750 000 1 250 000 13

10 000 000 –5 000 000 –3 000 000 0.85 –3 529 412 1 470 588 15

10 000 000 –5 000 000 –3 000 000 0.90 –3 333 333 1 666 667 17

10 000 000 –5 000 000 –3 000 000 0.95 –3 529 412 1 842 105 19

10 000 000 –5 000 000 –3 000 000 1.00 –3 000 000 2 000 000 20

10 000 000 –5 000 000 –3 000 000 1.05 –2 857 143 2 142 857 21

10 000 000 –5 000 000 –3 000 000 1.10 –2 727 273 2 272 727 23

Similar approaches can be adopted when measuring the impact of interest rate exposures. These
include assessing the impact of the notional changes in foreign exchange rates and commodity
prices on the underlying exposure and cash flow at risk. Cash flow at risk is a measure used to
estimate probability of loss based on statistical analysis of historical market price movements.

Proactive management, mitigation and insurance

Proactive management is a crucial stage of financial risk management as it looks at ways in which an
organisation can use FX volatility to its advantage, rather than simply see currency fluctuations as a
threat. Major opportunities for profits occur as frequently as potential exposures to losses. Windows
of opportunity should be documented in advance and marketing personnel should be educated
to be able to identify pricing anomalies caused by exchange rate movements. Strategic business
managers can add considerable value to their organisations by being proactive in this area.
MODULE 6

Mitigation is another important function of the financial risk manager. This role includes ensuring
that benchmarks are in place to flag both threats and opportunities, and, if a trigger level is
reached, that either hedging or other financial engineering techniques are already in place to
allow for a planned response to the change in currency prices.

Insurance is another useful way to approach FX risk management as the concept of insurance is
widely understood by non-financial professionals. While an option is in effect an insurance policy,
it may be more appropriate to ignore the ‘how’ (buy an option) and concentrate on the ‘what’
(protect the bottom line).
 Study guide | 353

Determining tolerances and goal-setting

Risk appraisal is based on the risk tolerances (often referred to as risk appetite) set by the board
and by business units which are the profit generators and are therefore the main focus of risk
management strategies within the organisation.

The probabilities of currencies moving through certain trigger levels could be assessed, but it
is probably a more logical strategy to simply assume that these levels will be breached and
concentrate on plans to manage the consequences. Therefore the key to risk appraisal is the
setting of contingency plans.

There are virtually unlimited numbers of potential solutions that combine various levels of:
• cash commitments (from zero to substantial);
• risk tolerance;
• opportunity management; and
• profit or cost protection.

A few of these alternative strategies are outlined in Table 6.3.

Table 6.3: FX option strategies

Goal Technique

Crisis protection only Out of the money option with strike price net of
costs at the critical level.

Even cheaper crisis protection Surrender the option if exchange rates move
sufficiently favourably.
Technically called a ‘knock-out option’.

Protection from unfavourable currency movements Buy a ‘put’ (importer).

beyond a designated profit level Buy a ‘call’ (exporter).

Take out protection without any cash outlay Buy a ‘collar’—first, set the required floor or
minimum exchange rate required to protect the
key profit level, then give up sufficient upside to
pay for the premium on the floor.

Benefit from falls that would otherwise harm Engineer a ‘reverse floater’—buy sufficient options/
the company forwards to reverse the original exposure direction.

In summary, by using options and forwards, any initial position or exposure can be adjusted into
the required exposure. MODULE 6

A specific case relating to an importer is outlined in Table 6.4. The actual numbers are not
intended to be verified for the purposes of this module—they are purely to illustrate that every
individual case will have its own costs and benefits, which should be able to be quantified and
communicated to senior management.
 354 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Table 6.4: Risk/return trade-off strategies (importer): Selected insurance alternatives

Goal/benchmark Minimum gross profit Maximum gross profit

1. No insurance: No limit (at current exchange No maximum

All cash flows remain floating rate of 0.9000: 17%) If the exchange rate reaches
(zero cover) 1.1000, gross profit is 23%

2. Full insurance: 17% 17%

Fix all cash flows (full cover) via
an FX forward at 0.9000

3. Financial year disaster 15% No maximum

insurance: Cost: AUD 2.00 per AUD 100 in Cost: AUD 2.00 per AUD 100
Protect minimum margin sales in sales
at 15% over 12 months via
purchasing a USD call/AUD
put option at 0.8500

4. Short-term disaster insurance: 15% No maximum

Protect minimum margin at Cost: AUD 1.60 per AUD 100 in Cost: AUD 1.60 per AUD 100
15% over three months via sales in sales
purchasing a USD call/AUD
put option at 0.8500

5. Cashless insurance: Zero cash 15% Maximum: 19%

cost but still protect minimum No direct cost No direct cost
15% over 12 months via an FX
collar with a lower rate (buy
USD call/AUD put) at 0.8500
and an upper rate (sell USD
call/AUD put) at 0.9500

A case study applying the above methodology follows. It involves an exporter rather than an
importer and traces the chronology of a typical risk management process.

Case Study 6.1: A

 usMobile Ltd—exports to America:
Appraising risks and setting benchmarks
Management brought to the board the good news that AusMobile Ltd had just won a USD 10 million
export contract that would double its forecast sales. The board of directors asked about the FX risk
involved and alternatives for managing that risk. Initially, management provided some next-to-useless
information. The board was informed that it had three options:
1. Lock in AUD 11.364 million by selling the USD 10 million forward (exchange rate of AUD/USD 0.8800).
MODULE 6

2. Do nothing. At the current exchange rate of AUD/USD 0.9000 the sale would return AUD 11.111 million
or AUD 253 000 less than the outright forward rate, but any movement in the exchange rate would
affect this amount.
3. Take out insurance through the use of options.

Analysis
The board needs to have this information put into terms all members can understand. The real issue
is the consequences for the company’s profitability and the company’s capacity to take on risk.

In the context of AusMobile Ltd the above information was processed and re-presented—the board
was informed that it could do one of two things:
1. Lock in a gross margin of 21 per cent (against the benchmark of 17%), thereby generating a net
profit of AUD 2.4 million. This would bring forecast net profit to budgeted rates for the year.
2. Protect the preset budgeted profit and allow for possible gains. At the current exchange rate,
margins are 19 per cent and net profit AUD 2.1 million. Every 1 cent movement in the Australian
dollar will increase or decrease net profit by approximately AUD 120 000. We will not achieve
budgeted profits should the exchange rate rise above AUD/USD 0.9200.
 Study guide | 355

The decision
Assuming for the moment that the choice is either (1) or (2), the AusMobile board is in the enviable
position to be able to opt for either solution. The first trades off possible further gains for an assured
result, while the second leaves it with the possibility of even greater profit, but an obligation to put
some trigger levels in to ensure that the budgeted profit is achieved. If the board opted for this latter
route, it could actually lock in a minimum acceptable net profit level either by paying a premium to
do so, or trading off some potential upside instead.

Adding insurance to the company’s choices

At this stage the company now has four basic choices:
1. It can opt to do nothing and allow net profits to vary with exchange rate movements. Where a
company can pass on these exchange rate movements, such as petrol companies in Australia,
such variations will be near to zero.
2. It can lock in outright rates and therefore remove FX as a direct factor in determining returns.
The downside of this policy is that the company will not benefit from favourable movements in
currencies, which may affect its competitiveness and its market share.
3. It can take out insurance, paying a premium to protect key levels of profitability or costs.
4. Finally, it can opt out of the cash premium in the previous solution by limiting the amount of
benefits it will enjoy should the exchange rate move favourably. This solution is marketed by
banks under at least a dozen different names, the most common of which are collars, nil-premium
cylinders and brackets.

Note: Figures in this case study have been assumed.

Case Study 6.2: FX Ltd and the capital expenditure decision

The board of FX Ltd has before it a final decision to purchase capital equipment. The equipment was
to cost the equivalent of AUD 5 million, payable in euro, but a favourable exchange rate movement
has reduced the outright forward price to AUD 4 600 000.

The question is what is the appropriate trade-off between risk and potential return that would be
acceptable to the board of FX Ltd? The figure below illustrates FX Ltd’s alternatives.

Foreign exchange risk management alternatives

AUD Capex, EUR component
5 400 000

5 200 000
Unhedged
5 000 000 100% hedge
Insurance
4 800 000
Nil premium
4 600 000
MODULE 6

4 400 000

4 200 000

4 000 000

3 800 000

3 600 000
0.5100 0.5600 0.6100 0.6600 0.7100
 356 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

At the outset it should be stressed that each of the four identified alternatives is rational in that
each involves different combinations of possible all-up costs, cash flows and ultimately net profits.
Further, they are all fairly priced (technically, the present values of the four alternatives are the same).

In this case, the board’s first decision was to ensure that the original cost of AUD 5 000 000 was not to be
risked, as that price would allow project costings to be met. This left three alternatives—which probably
should be delegated to management, but for the sake of this exercise, will be left with the board. Of these,
the insurance option was also dropped as FX Ltd had serious cash constraints at the time and hence
could not afford to pay the upfront cash for the option premium.

Two alternatives remained. These were to either fully hedge, thereby locking in a cost of just over
AUD 4 600 000, or take out a zero-cost collar, leaving some room for further savings but risking costs
as high as AUD 4 820 000.

The board accepted the CEO’s recommendation to take full cover and provide a known cost buffer
for the company.

Note: The discussions revolved around project and cash flow issues, not forecasts.

Step 4: Operations—implement strategies

This stage of financial risk management focuses on tactical issues and the implementation of
specific solutions.

It involves the quantification of the potential solutions and the practical issues involved, including
the accounting consequences (Step 4 and Step 5 of Figure 6.3) of FX exposure management.

Risk management for importers

If an Australian-based organisation imports goods, it will most likely need to make payment in
a currency other than its functional currency. If the AUD falls in value, the cost of those foreign
currency payments will rise. Assuming the organisation is unable to pass that additional cost
onto its customers, the lower AUD would increase costs and reduce profitability. To help protect
against this possible adverse currency move, importers may implement hedging strategies to
reduce currency risk.

Hedging with forward exchange contracts

A forward exchange contract (FEC) is an agreement between a bank and a customer for delivery,
at a future date, of a pre-specified amount of one currency for another. The advantages and
disadvantages of using an FEC include the following:
MODULE 6

Advantages
• Known fixed exchange rate.
• Easily pre-delivered or extended.
• No up-front costs.

Disadvantages
• Unable to benefit from favourable movements in the AUD.
• Obligation to deliver the currency at maturity.
 Study guide | 357

Forward exchange contracts and interest rate parity

It is important to note that when pricing an FEC, the concept of interest rate parity is central to
the pricing methodology. An FEC does not seek to predict the future rate of exchange but rather
to establish the rate of exchange that is to be provided under contract, given the current rate of
exchange and the interest rate differentials of each country.

Interest rate parity contends that the anticipated return on assets denominated in the domestic
currency will equate to the return on assets denominated in the foreign currency once currency
adjustments are accounted for. So, essentially, the exchange-rate-adjusted returns of both assets
will be equal. The forward exchange contract pricing methodology is based on this notion—the
FEC formula adjusts the current spot rate by the difference in the interest rates of the domestic
and foreign currencies. This is reinforced by the theory that there are no opportunities to profit
from arbitrage in an efficient economy, as a forward can be simulated by a spot transaction
combined with a deposit and loan. Investors will arbitrage markets until the forward rates align
with the interest rate parity.

IAS 39 Implications
FECs are considered a vanilla-type hedging instrument and can be used as a hedging instrument
under IAS 39. It is important for organisations seeking to adopt hedge accounting that they use
FECs in accordance with the requirements as set out in Module 7. (See ‘Hedge effectiveness’ in
Module 7 for details of how to achieve matched terms effectiveness.) Failure to achieve hedge
effectiveness can result in gains or losses from the hedge instruments being transferred to the
income statement. This could result in greater volatility in reported earnings.

A typical FEC transaction is illustrated in Example 6.4.

Example 6.4: FEC transaction

An Australian importer has imported machinery from the US with payment of USD 1 million due
in one month. The importer’s exposure is shown in the table below.

Impact of foreign exchange fluctuations

Exchange rate AUD cost

0.7500 1 333 333.33

0.8000 1 250 000.00

0.8500 1 176 470.59

0.9000 1 111 111.11 MODULE 6

0.9500 1 052 631.58

1.0000 1 000 000.00

This table shows that the AUD cost for the importer rises as the AUD depreciates.

For example, if the current AUD/USD spot rate of 0.9000 (= AUD 1 111 111.11)) changes to 0.7500 in
one month, the importer’s cost would be 1 000 000 / 0.7500 = AUD 1 333 333.33, an increase in cost
of AUD 222 222.22. To hedge this risk, the importer can enter into a one-month FEC at (say) 0.8950
and lock in an AUD cost of 1 000 000 / 0.8950 = AUD 1 117 318.44.
 358 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Impact of FEC on foreign exchange fluctuations

Exchange rate AUD cost with FEC

0.7500 1 117 318.44

0.8000 1 117 318.44

0.8500 1 117 318.44

0.9000 1 117 318.44

0.9500 1 117 318.44

1.0000 1 117 318.44

This table shows that once the importer has entered into an FEC at 0.8950, the AUD cost is fixed at
AUD 1 117 318.44, regardless of movements in the spot rate. The opportunity cost associated with
using a forward hedge is the potential lower cost that the importer gives up if the AUD appreciates.

Spot AUD/USD 0.9000, FEC rate AUD/USD 0.8950

Rate achieved AUD FEC
1.0000

0.9500

0.9000

0.8500

0.8000

0.7500
0.7500 0.8000 0.8500 0.9000 0.9500 1.0000
Spot rate
Spot rate FEC

This diagram illustrates the effective exchange rate that the importer will receive having entered into
an FEC. Regardless of any movement in the spot rate, the FEC guarantees the importer an exchange
rate of 0.8950.
MODULE 6

Pre-delivering and extending forward contracts

Often, a customer will not be totally sure of the timing of its cash flows when entering into an
FEC. Shipping delays or changes from the supplier may mean that it needs to adjust the terms
of the FEC.

Pre-delivering a contract
Pre-delivering simply means that the settlement date of the forward contract is brought forward.
Pre-delivery clauses are typically inserted in the forward agreement, especially when the timing
of cash flows or production is not certain.

Depending on the clause in the agreement, when pre-delivery is requested, the contract will
likely be marked-to-market to assess its current value (either positive or negative). This amount
may then be adjusted for a forward margin and/or interest to take into account time and interest
rate differentials between the two delivery dates.
 Study guide | 359

An exporter may have an FEC maturing on 30 September to convert USD into AUD. In order to
set the FEC (i.e. agree to convert USD to AUD at a future date), the bank would have borrowed
USD, converted it to AUD, then invested the AUD into the money markets. Then, at maturity of
the FEC, the bank would be able to pay AUD to the exporter, receive USD from the exporter,
and then repay the initial USD borrowings.

Assume the exporter receives its USD from a customer earlier than expected (e.g. on 31 August)
and so it needs to pre-deliver its contract. The exporter had previously taken out an FEC with
its bank to convert the USD, but that delivery date is still another month away. If the exporter
wants to pre-deliver the FEC, the bank can accept delivery (i.e. convert the USD to AUD for the
exporter). However, to do this, the bank would need to borrow AUD for a month (which is paid
to the exporter) and invest the USD for a month (which was received from the exporter). This will
result in a cost or benefit which will be passed on to the customer in the form of an interest rate
differential adjustment to the original contract. Note that no forecasting of future exchange
rates is involved in calculating the adjustment.

Note also that the exporter is not obligated to deliver early. The exporter may invest the USD
for the one-month period and settle the FEC on maturity.

Extending a contract
Again, assume our exporter has an FEC maturing on 30 September. In this instance, assume that
its payment has been delayed and the USD will not be received until 30 October. The exporter
could close out the existing contract, pay or receive any cash difference between that rate and
market spot rate and then enter into a new contract based on current rates. Generally, companies
prefer to adjust the current contract rather than pursue the process of entering into a new deal.
This is known as an historic rate rollover (HRR).

HRRs have been used to hide losses, as was the case with Amalgamated Wireless Australasia
(AWA) Ltd. In that case, AWA was realising FECs when they were better than the market,
but extending the FECs if they were showing a loss on settlement. This meant that AWA had
many FECs with no underlying exposure, which had the result of hiding losses and creating large
speculative positions. It is important for companies to ensure that HRRs are only undertaken when
there is a genuine trade reason for extending the contract, and not just to enable them to take
advantage of better market rates. Many treasury policies prohibit the use of HRRs for this reason.

➤➤Question 6.4
An Australian importer has to pay USD 5 million in 90 days in settlement of a contract for
the purchase of goods from a US-based supplier. Market data is supplied as follows: MODULE 6
AUD/USD spot rate: AUD/USD 0.9000
90-day interest rate in Australia: 6% p.a.
90-day interest rate in United States: 4% p.a.

Calculate the 90-day forward price.

(Please refer to the FEC formula in Module 4.)
 360 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Hedging with cross-currency interest rate swaps

A cross-currency interest rate swap (CCIRS) is an agreement between two parties to exchange
interest payments and principals denominated in two different currencies. A CCIRS is an ideal
instrument to hedge foreign currency debt or foreign currency assets (i.e. economically the
CCIRS synthetically converts the foreign currency asset or liability into AUD).

Figure 6.6 and Table 6.5 illustrate the flow of funds involved in a typical AUD/USD cross-currency
swap hedging foreign currency bank debt. At the start of the contract, Company A will receive
the foreign currency borrowed funds from Bank X and then under the CCIRS pays the same
USD to Bank Y (the CCIRS counterparty) in return for AUD at the spot rate. During the contract
term, under the CCIRS, Company A pays AUD 3 million at BBSW + a + b, and receives USD 3
million at LIBOR from Bank Y every three months, where ‘a’ is the cross-currency basis or cross-
currency spread, and is agreed upon by the counterparties at the start of the contract. ‘b’ reflects
the credit margin and the banks profit margin. The cross-currency basis margin is determined
in FX markets by supply and demand for different currencies. The credit margin will depend on
Company A’s credit risk to the bank and the banks’ profit margin will depend on competition
within the market.

At the maturity of the contract, Company A receives the original USD amount from Bank Y, and in
return Bank Y receives AUD from Company A. The exchange rate used at maturity is the same FX
spot rate as at the start of the contract. Company A will utilise the USD received under the CCIRS
to settle the bank loan from Bank X. The interest paid and received under the CCIRS follows the
interest rate parity theory mentioned above and can be fixed or floating. Looking at the cash
flows in Table 6.5, the USD under the bank loan is converted to AUD via the CCIRS. Likewise the
interest payment has been converted to AUD.

Figure 6.6: CCIRS hedges a USD loan

Receive USD loan

Company A Bank X

Uses a CCIRS swap Debt provider

to synthetically Pay USD interest over the life of the loan
convert a USD and repay USD principal at maturity
bank loan into an
AUD exposure
Pay USD principal at inception, pay interest
over the term of the CCIRS and repay
AUD prinicpal at maturity
Bank Y

CCIRS
counterparty
MODULE 6

Received AUD principal at inception,

receive USD interest over the term of the
CCIRS and receive USD principal at maturity
 Study guide | 361

Table 6.5: Cash flows of CCIRS

Timeline Transactions Cash Debt CCIRS FX rate

In In Receive Receive
(out) (out) (Pay) (Pay)
USD AUD USD USD AUD

Day 1 Receive debt from 2 000 000 –2 000 000

bank at USD 3-month
LIBOR

Day 1 Under CCIRS swap

principals on CCIRS
at spot rate

Pay away USD –2 000 000 –2 000 000

Receive AUD 2 222 222 2 222 222 0.9000

Day 90 Pay for debt USD –20 000 20 000

3-month LIBOR @ 1%

Day 90 Under CCIRS

Receive USD 20 000 20 000

3-month LIBOR @ 1%

Pay AUD BBSW plus –111 111 –111 111

margin @ 5%

(Only one interest

rate payment is
shown)

At Settle bank debt –2 000 000 2 000 000

maturity

Under CCIRS swap

principals on CCIRS
at spot rate

Receive USD 2 000 000 2 000 000

Pay AUD –2 222 222 –2 222 222 0.9000

MODULE 6
 362 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Hedging with options

As an alternative to entering into an FEC, the importer can purchase an AUD put option (foreign
currency call). The key benefit of the bought AUD put over the FEC is that the importer is able to
participate in favourable currency moves while being protected against adverse currency moves.
Bought currency options also carry no obligation for the importer to deliver, which is useful when
hedging exposures that are uncommitted. The key disadvantage is that bought options require
the payment of a premium.

Description
A bought AUD put (foreign currency call) gives an importer the right, but not the obligation,
to sell AUD and buy the foreign currency at an agreed strike price at a future date. Through the
purchase of an AUD put, the importer is guaranteed a minimum worst-case exchange rate with
unlimited participation in any favourable movements in exchange rates.

Advantages
• Allows full participation in favourable movements in the spot rate.
• No obligation to deliver.
• Fully eliminates the risk of adverse currency movements to the level of the strike.

Disadvantages
• Up-front premium.
• Not able to pre-deliver European options prior to maturity. Use would require the cancellation
of the option and any refund would be subsequently embedded in the prevailing spot rate.

At maturity, the following scenarios could occur:

• If on maturity the spot rate is below the strike price, the importer would exercise its right and
purchase the foreign currency at the strike price.
• If on maturity the spot rate is higher than the strike price, the importer would allow the option
to lapse worthless, and transact in the spot market.

Example 6.5: Hedging with options

An Australian importer is expecting to make USD 1 million worth of purchases in three months’ time,
although there is a chance that the purchases will not occur. The company decides to put a cap on
the possible costs of the purchase. To do this, it buys an AUD put option to protect against a possible
fall in the AUD exchange rate. The put option also provides the organisation with flexibility should
the purchases not occur as it is not obliged to buy the US dollars.
MODULE 6

Assume the following details and consider the following diagram.

Spot AUD/USD 0.9000

Strike price 0.8800
Maturity 3 months
Amount USD 1 000 000
Premium 150 points
Break-even 0.8650
 Study guide | 363

Bought AUD 0.8800 put option

Rate achieved AUD bought put
1.0000

0.9800

0.9600

0.9400

0.9200

0.9000

0.8800

0.8600

0.8400

0.8200

0.8000
00 100 200 300 400 500 600 700 800 900 000 100 200 300 400 500 600 700 800 900 000
80 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0
0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0.1

Spot rate Bought put Spot rate

This diagram illustrates the effective exchange rate that an importer would achieve from hedging with
a bought AUD put option.

The diagram is not a pay-off diagram of a bought put. It is the diagram that banks use in their
product disclosure statements (PDSs) and which companies must be given by their financial
institutions.

The diagram shows that the worst-case effective exchange rate the importer would achieve is 0.8650
(the 0.8800 strike minus 150 points for the cost of the option). If the AUD rises above the strike rate, the
importer would participate in this favourable movement. At maturity, the following scenarios could occur:
• If, on expiry, the spot rate is below 0.8800, the importer would exercise its right and deliver the
AUD at 0.8800. The effective exchange rate achieved by the importer would be 0.8650 (the strike
price minus the cost of the option).
• If, on expiry, the spot rate is higher than the strike price, the importer would allow the option to
lapse worthless, and sell the AUD at the prevailing spot rate. The effective rate achieved by the
importer would be the spot rate minus the cost of the option. If the spot rate at expiry is 0.9600,
the effective exchange rate for the importer would be 0.9450.

Impact of AUD put options on foreign exchange fluctuations

MODULE 6
Exchange rate USD cost Effective AUD cost with AUD put*

0.6000 USD 1 000 000 AUD 1156069

0.6500 USD 1 000 000 AUD 1156069

0.7000 USD 1 000 000 AUD 1156069

0.8500 USD 1 000 000 AUD 1156069

0.9000 USD 1 000 000 AUD 1129943

0.9500 USD 1 000 000 AUD 1069518

1.0000 USD 1 000 000 AUD 1015228

* Includes the option premium.

The table shows that with an AUD put option, the maximum AUD cost for the importer is
AUD 1 156 069. The put option allows the importer to achieve a lower cost as the AUD strengthens.
 364 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

IAS 39 Implications
Bought options are considered a vanilla-type hedging instrument and can be used as a hedging
instrument under IAS 39. However, only the intrinsic value of the option achieves hedge
accounting. (This will be discussed further in Module 7.)

Hedging with a collar option

An alternative to purchasing a put option, which requires the payment of a premium, is to enter
into a combination of options known as a nil-premium collar. The advantage of a collar over a
bought put is that there is no premium required; the main disadvantage is that the benefit the
importer receives from a higher AUD is limited.

Description
This structure is a combination of options whereby the importer purchases an AUD put/foreign
currency call and simultaneously sells an AUD call/foreign currency put to offset the cost of the
AUD put, thereby creating a collar with a nil premium.

This provides the importer with the protection against a depreciation of the AUD to the level of
the put, though restricting any benefit from a rising AUD down to the level of the sold call.

Advantages
• Provides effective insurance whilst allowing some participation in favourable currency
movements.
• Fully eliminates risk of adverse currency movements to the level of the put.

Disadvantages
• Restriction within the currency band.
• Obligation to deliver on the sold position.
• Difficult to pre-deliver prior to maturity. Use would require the cancellation of the option and
any refund or cost subsequently embedded in the prevailing spot rate.

IAS 39 Implications
Sold options do not qualify for hedge accounting under IAS 39, unless they are part of a bought
structure with no net premium payable (see Module 7). The nil-premium collar in Case Study 6.3
satisfies this requirement and therefore qualifies as a hedging instrument, although limited to
the intrinsic value of the options. It is emphasised that it is important for organisations seeking
to adopt hedge accounting to use options in accordance with the requirements as set out
MODULE 6

in Module 7.
 Study guide | 365

Case Study 6.3: Hedging with a collar option

An Australian importer is expecting to make USD 1 million worth of purchases in three months’ time.
The organisation wants to cap the possible costs of the purchase, but would like to benefit if the AUD
were to rise. The organisation does not want to pay any premium. To do this, the organisation decides
to enter into a nil-premium collar.

Assume the following details and consider the diagram below.

Spot AUD/USD 0.9000

Maturity 3 months
Amount USD 1 000 000
Bought AUD put strike 0.8800
Sold AUD call strike 0.9200
Premium Nil

Importer’s AUD/USD collar

Rate achieved Collar option
1.0000

0.9800

0.9600

0.9400

0.9200

0.9000

0.8800

0.8600

0.8400

0.8200

0.8000
00 100 200 300 400 500 600 700 800 900 000 100 200 300 400 500 600 700 800 900 000
80 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0
0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0.1

Spot rate Collar option Spot rate

This diagram illustrates the effective exchange rate that an importer would achieve from hedging
with a nil-premium collar. This diagram is not an option pay-off diagram. It illustrates that the best
case exchange rate the importer will achieve is 0.9200. The worst-case rate the importer will achieve
is 0.8800. Between 0.8800 and 0.9200 both options expire worthless and the importer will deal at MODULE 6
the prevailing spot rate.

At maturity, the following scenarios could occur (for importers):

• If, on expiry, the spot rate is lower than the strike for the AUD put, the importer would exercise
the right to purchase the foreign currency at 0.8800.
• If, on expiry, the spot rate is between the two strikes (0.8800–0.9200), the importer would convert
at the prevailing spot rate.
• If, on expiry, the spot rate is above the strike of the AUD call option, the importer would be obliged
to take delivery of the foreign currency at 0.9200.

Strike rate(s) Best case Worst case

Put 0.8800 – Call 0.9200 0.9200 0.8800
 366 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

The table below shows that with a nil-premium collar, the maximum cost for the importer is
AUD 1 136 363.64, while the minimum cost for the importer is AUD 1 086 956.52.

Impact of nil-premium collar on foreign exchange fluctuations

Exchange rate AUD cost with collar

0.8400 1 136 363.64

0.8500 1 136 363.64

0.8600 1 136 363.64

0.8700 1 136 363.64

0.8800 1 136 363.64

0.8900 1 123 595.51

0.9000 1 111 111.11

0.9100 1 098 901.10

0.9200 1 086 956.52

0.9300 1 086 956.52

0.9400 1 086 956.52

0.9500 1 086 956.52

0.9600 1 086 956.52

➤➤Question 6.5
You are the financial controller at an Australian company that has just contracted to purchase
equipment from the United States at a cost of USD 2 million. Payment is required in six months.
The current spot rate is AUD 0.9000. You have been asked by the CFO to do the following:
(a) Explain the type of risk to which the company is exposed as a result of this purchase.
(b) Explain what the impact on the company would be if the AUD fell to 0.8000 in six‑months’
time.
(c) Calculate the effective AUD cost of the equipment in each of the following circumstances
(assume the spot rate has fallen to 0.8000 in six months’ time):
(i) The company had left its currency exposure unhedged.
(ii) The company had entered into an FEC at a rate of 0.8950.
(iii) The company had bought an AUD put option with a strike rate of 0.8800 and the cost
MODULE 6

of the option was 90 points.

(d) Which of the strategies in part (c) would you recommend if the company wanted to protect
against a fall in the AUD but still benefit if the AUD rose?
 Study guide | 367

Risk management for exporters

The hedging strategies used by exporters are basically the same as those used by importers
except that exporters are selling foreign currency and buying AUD.

Note about diagrams used in this section

In this section two different types of diagrams are used to illustrate FX exposures, hedging
instruments and the effective hedged position. The first type of diagram (also used in the
importer section) shows the effective exchange rate achieved once the hedging instrument is
combined with underlying exposure. These are not pay-off diagrams of the hedging instrument.
These diagrams are typically used by banks in their product disclosure statements which
the Australian Securities and Investments Commission (ASIC) requires to be provided to the
bank’s clients.

The second type of diagram used in this section shows the pay-off of the unhedged position,
the pay-off of the hedging instrument and the pay-off of the final position, all shown in the one
diagram. These diagrams are typically used in textbooks and can be useful in demonstrating
to senior management the impact of hedging. It is important to be familiar with both types of
diagrams since both are used in practice.

The other difference between the two diagrams is that one uses an exchange rate as the Y axis
and the other uses a dollar amount. With an exporter, the amount of AUD received falls as the
AUD exchange rate rises and the amount of AUD received rises as the AUD exchange rate falls.
This means that the final exposure and effective exchange rate lines on these two diagrams will
appear opposite.

Hedging with forward exchange contracts

A forward exchange contract (FEC) is an agreement between a bank and a customer for delivery,
at a future date, of a pre-specified amount of one currency for another. The advantages and
disadvantages of using FECs are explained earlier in this module under the heading ‘Risk
management for importers’.

Example 6.6: Hedging with FEC

An Australian company has exported goods to the United States with payment of USD 2 million to be
received in three months. The exporter’s exposure arises from the risk of an appreciation of the AUD
which would decrease its AUD revenue, as shown in the table below.

Impact of foreign exchange fluctuations

Exchange rate AUD receipt against USD 2 million MODULE 6

0.7500 2 666 666.67

0.8000 2 500 000.00

0.8500 2 352 941.18

0.9000 2 222 222.22

0.9500 2 105 263.16

1.0000 2 000 000.00

1.0500 1 904 761.90

1.1000 1 818 181.82

This table shows that the AUD receipts for the exporter decline as the AUD appreciates.
 368 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

If the current AUD/USD spot rate of 0.9000 (= AUD 2 222 222.22) changes to 1.0000 in three months,
the exporter’s revenue cost would be 2 000 000 / 1.0000 = AUD 2 000 000.00, a reduction in revenue
of AUD 222 222.22. To hedge this risk, the exporter can enter into a three-month forward contract
at 0.8950 and lock in the AUD revenue at 2 000 000 / 0.8950 = AUD 2 234 636.87. Once the forward
contract has been entered into, the exporter does not need to worry about exchange-rate movements
as it will be exchanging USD at the rate of 0.8950, regardless of the market rate on the settlement date.
Therefore, the exporter will receive AUD 2 234 636.87, regardless of the market rate on the settlement
date as shown in the table below.

Impact of FEC on foreign exchange fluctuations

Exchange rate AUD receipt with FED against USD 2 million

0.7500 2 234 636.87

0.8000 2 234 636.87

0.8500 2 234 636.87

0.9000 2 234 636.87

0.9500 2 234 636.87

1.0000 2 234 636.87

1.0500 2 234 636.87

1.1000 2 234 636.87

The opportunity cost associated with using a forward hedge is the potential higher revenue that the
exporter gives up if the AUD depreciates.

Spot AUD/USD 0.9000, FEC rate AUD/USD 0.8950

Rate achieved
AUD FEC
1.0000

0.9800

0.9600

0.9400

0.9200

0.9000

0.8800

0.8600
MODULE 6

0.8400

0.8200

0.8000
00 100 200 300 400 500 600 700 800 900 000 100 200 300 400 500 600 700 800 900 000
80 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0
0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0.1

Spot rate FEC Spot rate

This figure shows the result of entering into the FEC as it will be represented to clients by banks in
their product disclosure statements (PDSs). These PDSs are regulated by ASIC. They relate only to
a bank’s product and do not incorporate any underlying exposure.
 Study guide | 369

For the purposes of financial risk management and in order to illustrate the effectiveness of any hedge,
a further diagram would be required in order to show the overall picture—initial or underlying exposure,
the pay-off on the FEC or hedge instrument and the final position.

This is illustrated in the diagram below.

Exposure management using forwards

2 500 300 000
2 475
2 450
2 425 200 000
2 400
2 375
AUD’000 per USD 2 million

2 350

AUD $ pay off on FEC

2 325 100 000
2 300
2 275
2 250 0
2 225
2 200
2 175 –100 000
2 150
2 125
2 100
2 075 –200 000
2 050
2 025
2 000 –300 000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00
0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0.1

Hedged with FEC Unhedged Pay off on FEC Spot rate

(final exposure)

The ‘Exposure management using forwards’ diagram starts with the underlying USD 2 million of export
receipts used in the diagram before it.

If the exporter decides to ‘do nothing’ and remain unhedged, the AUD value of the contract will be
higher the stronger the USD (or the weaker the AUD) becomes and will get progressively lower as the
USD weakens (AUD strengthens). If the USD 2 million is sold forward, the effect is to provide a pay-off
exactly offsetting the unhedged exposure.

The overall result is a locked-in amount of AUD 2 234 637 (USD 2 million/0.8950). From this the exporter
can calculate its overall margin or profit on the transaction.

Hedging with a bought Australian dollar call option (foreign currency put)
As an alternative to entering into an FEC, the exporter can purchase an AUD call option (foreign MODULE 6
currency put). The key benefit of the bought AUD call over the FEC is that the exporter is able to
participate in favourable currency movements, while being protected against adverse currency
movements. Bought currency options also carry no obligation for the exporter to deliver, which is
useful when hedging exposures that are uncommitted. The key disadvantage is that bought
options require the payment of a premium.

Description
A bought AUD call (foreign currency put) gives an exporter the right but not the obligation
to buy AUD and sell the foreign currency at an agreed strike price at or up to a future date.
Through the purchase of an AUD call, the exporter is guaranteed a minimum AUD exchange
rate with unlimited upside should the foreign currency appreciate.
 370 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Advantages
• Allows full participation in favourable movements in the spot rate.
• No obligation to deliver.
• Fully eliminates the risk of adverse currency movements beyond the level of the strike.

Disadvantages
• Up-front premium.
• Not able to pre-deliver European options prior to maturity.

At maturity, the following scenarios could occur:

• If, on maturity, the spot rate is above the strike price, the exporter would exercise its right to
deliver foreign currency at the strike price.
• If, on maturity, the spot rate is lower than the strike price, the exporter would allow the option
to lapse worthless, and transact in the spot market at a better rate than that obtainable by
exercising the option.

IAS 39 Implications
Bought options are considered a vanilla-type hedging instrument and can be used as a hedging
instrument under IAS 39. However, only the intrinsic value of the option achieves hedge
accounting. (This will be discussed further in Module 7.)

Example 6.7: H
 edging with a bought Australian dollar
call option
An exporter with an AUD functional currency has made USD 2 million worth of sales for payment in
three months’ time. The exporter decides to buy an AUD call option to protect against a possible rise
in the AUD/USD exchange rate.

Assume the details below and consider the diagram that follows them.

Spot AUD/USD 0.9000

Strike price 0.9200
Maturity 3 months
Amount USD 2 000 000
Premium 90 points
Break-even 0.9290
MODULE 6
 Study guide | 371

Bought AUD/USD 0.9200 call

Rate achieved AUD bought call
1.0000

0.9800

0.9600

0.9400

0.9200

0.9000

0.8800

0.8600

0.8400

0.8200

0.8000
00 100 200 300 400 500 600 700 800 900 000 100 200 300 400 500 600 700 800 900 000
80 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0
0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0.1
Spot rate Bought call Spot rate

The diagram above illustrates the effective exchange rate that an exporter would achieve from
hedging with a bought AUD call. This diagram is not a pay-off diagram of a bought call. It shows that
the effective worst-case exchange rate that the exporter would achieve is 0.9290 (the 0.9200 strike
plus 90 points for the cost of the option). As the AUD declines, the exporter would participate in this
favourable movement.

At maturity, the following scenarios could occur:

• If on expiry the spot rate is above 0.9200, the exporter would exercise the right to deliver USD at
0.9200. The effective exchange rate achieved by the exporter would be 0.9290 (the strike price
+ the cost of the option).
• If on expiry the spot rate is lower than the strike price, the exporter would allow the option to
lapse worthless and sell the USD at the prevailing spot rate. The effective rate achieved by the
exporter would be the spot rate plus the cost of the option. If the spot rate at expiry is 0.8000,
the effective exchange rate for the exporter would be 0.8090.

Impact of AUD call on foreign exchange fluctuations

Exchange rate AUD receipt against USD 2 million with AUD call*

0.8000 AUD 2 472 187.886 MODULE 6

0.8500 AUD 2 328 288.708

0.9000 AUD 2 200 220.022

0.9500 AUD 2 152 853.000

0.9700 AUD 2 152 853.000

0.9800 AUD 2 152 853.000

* Net of option premium.

This table shows that with an AUD call option, the minimum amount of AUD that the exporter will receive
is AUD 2 152 853. The call option allows the exporter to receive more AUD as the AUD falls.
 372 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

For risk management purposes, and for the purpose of meeting IFRS requirements to show that the
hedge is effective, an alternative way to illustrate the effect of buying the AUD call on the exporter’s
overall position is provided in the figure below.

Financial risk management using options

Rate achieved AUD bought call
2 500 300 000
Thousands

2 475
2 450
2 425 250 000
2 400
2 375
2 350 200 000
AUD per USD 2 million

2 325
2 300
150 000
2 275
2 250
2 225
100 000
2 200
2 175
2 150 50 000
2 125
2 100
2 075 0
2 050
2 025
2 000 –50 000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
. 80 .81 .82 .83 .84 .85 .86 .87 .88 .89 .90 .91 .92 .93 .94 .95 .96 .97 .98 .99 .100
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Hedged with call Unhedged Pay off on call Spot rate

(final exposure)

If the exporter takes no action to manage the currency risk, a fall in the value of the USD (which equates
to an appreciation of the AUD) will leave the exporter vulnerable to a loss of income. With the call
in place, the exporter can still benefit from any rise in the value of the USD but is protected against
significant depreciation in the USD’s value.

➤➤Question 6.6
(a) An Australian-based exporter has bought an AUD call option with a strike of 0.9000. Explain
what the exporter would do if the AUD was trading at 0.9300 when the option expires.
(b) Assuming the option cost 90 points, what would be the exporter’s effective exchange rate?

Exporters hedging with a collar option

An alternative to purchasing a call option (which requires the payment of a premium) is to enter
MODULE 6

into a combination of options known as a nil-premium collar. The advantage of a collar over a
bought call is that there is no premium required. The main disadvantage is that the benefit the
exporter receives from a lower AUD is limited.
 Study guide | 373

Description
This structure is a combination of options whereby the exporter purchases an AUD call/foreign
currency put and simultaneously sells an AUD put/foreign currency call to offset the cost of
the AUD call, thereby creating a collar with a nil premium.

This provides the exporter with protection against an appreciation of the AUD to the level of the
call, though restricting any benefit from a falling AUD to the level of the sold put.

Advantages
• Provides cheap insurance while allowing some participation in favourable
currency movements.
• Fully eliminates risk of adverse currency movements to the level of the call.

Disadvantages
• Restriction within the currency band.
• Obligation to deliver on the short position.
• Difficult to deliver prior to maturity. Use would require the cancellation of the option and any
refund or cost to be subsequently embedded in the prevailing spot rate.

IAS 39 Implications
Sold options do not qualify for hedge accounting under IAS 39, unless they are part of a
bought structure with no net premium payable. (Please refer to the discussion in Module 7.)
The nil‑premium collar in Case Study 6.4 satisfies this requirement and therefore qualifies as a
hedging instrument, although limited to the intrinsic value of the options. It is emphasised that it
is important for organisations seeking to adopt hedge accounting to use options in accordance
with the requirements in the standard, as will be discussed further in Module 7.

Case Study 6.4: Hedging with collar option

An Australian-based exporter is expecting to make USD 500 000 worth of sales in six months’ time.
The exporter is willing to accept some AUD volatility, but wants to protect against a substantial rise
in the AUD. It does not want to pay any option premium. A collar option provides the exporter with
protection against an appreciation of the AUD to the level of the bought call, but restricts any benefit
from a falling AUD down to the level of the sold put.

Assume the details below and consider the diagram that follows them.

Spot AUD/USD 0.9000

MODULE 6
Maturity 6 months
Amount USD 500 000
Bought AUD call strike 0.9200
Sold AUD put strike 0.8800
Premium Nil
 374 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Exporter’s AUD/USD 0.8800 / 0.9200 collar

Rate achieved
Collar option
1.0000

0.9800

0.9600

0.9400

0.9200

0.9000

0.8800

0.8600

0.8400

0.8200

0.8000
00 100 200 300 400 500 600 700 800 900 000 100 200 300 400 500 600 700 800 900 000
80 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0
0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0.1

Spot rate Collar option Spot rate

This diagram illustrates the effective exchange rate that an exporter would achieve from hedging
with a nil-premium collar. This diagram is not an option pay-off diagram. It shows that the best-case
exchange rate the exporter will achieve is 0.8800. The worst-case rate the exporter will achieve is
0.9200. Between 0.8800 and 0.9200, both options expire worthless and the exporter will deal at the
prevailing spot rate.

At maturity, the following scenarios could occur (for exporters):

• If, on expiry, the spot rate is lower than the strike for AUD put, the exporter will be obliged to
deliver the foreign currency at 0.8800.
• If, on expiry, the spot rate is between the two strikes (0.8800–0.9200), the exporter would convert
at prevailing spot rate.
• If, on expiry, the spot rate is above the strike of the call option, the exporter would exercise the
right to deliver the foreign currency at 0.9200.

Strike rate(s) Best case Worst case

Call 0.9200 – Put 0.8800 0.8800 0.9200

Impact of collar option on foreign exchange fluctuations

Exchange rate AUD receipts against USD 500 000 with collar

0.87 568 181.82

MODULE 6

0.88 568 181.82

0.89 561 797.75

0.90 555 555.56

0.91 549 450.55

0.92 543 478.26

0.93 543 478.26

The table above shows that with a nil-premium collar, the minimum that the exporter will receive is
AUD 543 478.26 and the maximum AUD receipt is AUD 568 181.82.
 Study guide | 375

In order to determine the effectiveness, the following information may be provided—in this case,
in the diagram below.

Exporter’s collar: Final achieved result

Rate achieved
60 000
Thousands

620

40 000
600

20 000
580
AUD per USD 500 000

560
–20 000

540
–40 000

520 –60 000

500 –80 000

00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
. 80 .81 .82 .83 .84 .85 .86 .87 .88 .89 .90 .91 .92 .93 .94 .95 .96 .97 .98 .99 .100
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Hedged with collar Unhedged Pay off on collar Spot rate

(final exposure)

Using this diagram, the risk management aspects of the collar in the context of the underlying exposure
become clear. Unhedged, the exporter is exposed to considerable potential volatility in revenue.
However, with the collar superimposed on the underlying position, the final hedged position shows
far less volatility and a known best and worst level of returns per USD 500 000.

The diagram illustrates the AUD outcomes shown in the preceeding table. The pay-off on the collar
offsets the exposure of the exporter to loss of revenue beyond an exchange rate of AUD/USD 0.9200
but at the cost of foregoing any further benefits of the USD strengthening beyond AUD/USD 0.8800.
These two levels were chosen so that the total premium payable on the bought option equalled the
premium received on the sold option (the pair making up the ‘collar’). Thus, no net cash premium
is payable.

Hedging instrument summary

Table 6.6 summarises the key features of the various hedging instruments.
MODULE 6

Table 6.6: Hedging instrument summary for importers and exporters

Suitable for hedging Participation

in favourable
currency/ Potential
Hedging Committed Uncommitted price Premium IAS 39
instrument exposures exposures movements payable effectiveness*

FEC/Forwards     

Bought option   Unlimited  

Nil-premium collar   Limited  

* This is only an indication of the potential effectiveness of these products. The actual effectiveness
of these products for IAS 39 purposes will depend on the manner in which they are used (see the
discussion in Module 7) and with options, the effectiveness is limited to the intrinsic value. The use
of these products alone does not guarantee that hedge effectiveness will be achieved.
 376 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

➤➤Question 6.7
You are the treasurer of an Australian-based exporter and the sales department is forecasting
sales in six months’ time of USD 3 million. Your sales department forecasts are not always reliable.
You are concerned that the value of the AUD may rise, eroding the profit margin on the sales,
so you decide to hedge your foreign exchange exposure. The company’s treasury policy allows the
use of either FECs or bought AUD call options. You obtain the following quotes from your bank:
(a) Six-month FEC @ 0.9200 for USD 3 000 000.
(b) AUD call with a strike rate of 0.9200, for USD 3 000 000 costing 95 points.
Based on best practice risk management, which of these two hedging strategies would you adopt?

Step 5: Accounting and controls

Accounting for FX derivatives is covered in Module 7 and controls for trading derivatives are
covered in Module 8.
MODULE 6
 Study guide | 377

Part B: Commodity risk

Introduction
Commodities are basically physical substances that can be extracted directly from the
environment, processed and sold commercially. The main categories of commodities are metals,
soft commodities, livestock and energy.

Figure 6.7: Commodity types

Commodities

Softs Precious Base metals Energy Livestock Bulk

Wheat metals Copper Crude oil Cattle Iron ore
Corn Gold Aluminium Natural gas Lean hogs Coal
Sugar Silver Nickel Heating oil Pork bellies
Soybean Platinum Lead Electricity
Rice Palladium Zinc Coal
Coffee Tin Carbon

Failing to effectively manage commodity and FX risk can have disastrous consequences for
businesses as demonstrated in Case Study 6.8: ‘Pasminco Ltd’ at the conclusion of this module.

Pasminco hedged only its currency risk and left its exposure to the zinc price unhedged. The zinc
price fell sharply, which meant that the company did not receive enough USD from its zinc sales
to deliver against its FX contracts. The company was placed in voluntary administration with
debts in excess of AUD 3.4 billion as a result of mismanaging its zinc and currency exposures.

Most Australian companies tend to use the over-the-counter (OTC) market to hedge commodity
risk given the flexible nature of those products compared to the futures market. Commodity
risks may also be managed using futures which are dealt on recognised exchanges such as the
ASX, Commodity Exchange of New York, Chicago Board of Trade and London Metals Exchange.
These are referred to as ‘exchange-traded’ instruments.

Case Study 6.5: Commodity and foreign exchange risk

The AusBrew brewery uses aluminium in the production of beer cans and is concerned that the price of
MODULE 6
aluminium will rise. The company decides to hedge its 1000 tonne aluminium requirement for the next
12 months at USD 2000 per tonne. The total amount of USD 2 million is payable in six months’ time.
The company does not hedge the currency risk and the AUD subsequently falls from 0.9000 to 0.8000.

Had the company hedged the currency risk at 0.9000, the AUD cost of the aluminium would have
been AUD 2 222 222.22 ($2m / 0.9000) but with the lower AUD, the cost will now be AUD 2 500 000.00
($2m / 0.8000).

When companies are subject to both commodity price risk and currency risk, consideration must
be given to both risks and, when unhedged, the degree of correlation between the currency and
the commodity. Some resource companies in Australia have argued that there is a natural hedge
between the AUD and commodity prices due to the correlation of the AUD and certain commodity
prices (i.e. as the USD‑denominated commodity price falls, the AUD may fall in a similar fashion,
reducing the impact of the commodity price drop). However, historical correlations are typically
only stable over short periods and a high degree of scepticism should be exercised over any risk
management policy that relies on certain historical correlations to continue into the future.
 378 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Contango and backwardation

Like the FX market, commodities can be traded in the spot market (i.e. two days forward) or
using forward contracts (i.e. > two days forward). In FX markets the forward price is determined
by interest rate differentials. In commodity markets this is not necessarily the case. The terms
contango and backwardation are used to describe the forward price of a commodity in relation
to the spot price as discussed in Module 4.

Figure 6.8: Backwardation and contango

USD/ USD/
barrel Million tonnes
110 2 200

105
2 100

100

2 000
95

Aluminium
Crude oil

90 1 900

85
1 800

80

1 700
75

70 1 600
th th th th th th th th th th th th th th th th th th th th
th
m m m m m m m m m m m m m m m m m m m m m
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

Forward prices as at 2 Aug 2013

Crude oil Aluminium

Source: Based on data from London Metals Exchange 2013, ‘LME aluminium’ (2 August)
www.lme.com/metals/non-ferrous/aluminium and Trading Charts 2013, ‘Light crude oil’ (2 August),
both accessed August 2013, http://futures.tradingcharts.com/marketquotes/CL_.htm.

Consider the current spot price and the forward price of aluminium depicted in Figure 6.8. There
are costs associated with holding this non-perishable commodity, in particular the cost of holding it
MODULE 6

in warehousing and the opportunity cost associated with the outlay of funds today as opposed to
in the future. The aluminium price is currently in contango, given these costs. Conversely, the spot
price of crude oil is currently higher than the forward price; this could be due to a significant
short‑term increase in demand for crude oil, but as is often the case, it may be more a consequence
of supply-side issues. The crude oil price is often in normal backwardation because of the lack of
availability of crude oil relative to the demonstrated demand. It may be the case that the market
has factored future increased releases of crude oil by suppliers into the futures price, resulting in
the lower forward price.
 Study guide | 379

Soft commodities
Soft commodities refer to those commodities which are grown rather than mined, such as wheat,
corn and sugar. Wheat and corn are the largest produced crops. More recently commodities
such as sugar, sorghum, corn and wheat are being increasingly used in the production of liquid
biofuels such as ethanol. This growth in the use of grains in the production of liquid biofuels
has the potential to exert significant pressure on grain demand and prices, despite making up
a relatively small part of the global energy market.

Agricultural commodities are traded on futures exchanges around the world. The most active
futures exchange for soft commodities is the Chicago Board of Trade (CBOT) which is part of
the CME Group. In Australia the Australian Securities Exchange (ASX) offers futures and option
contracts on wheat (east coast and west coast) sorghum, barley and canola.

In addition to futures markets, soft commodities are also traded in the OTC market, where the
producers and commodity buyers deal directly with a financial institution rather than through
an exchange. The majority of producers and buyers tend to use the OTC market to hedge,
as OTC derivatives such as swaps, forwards and options can be tailored to the specific amounts,
dates and prices they require as opposed to exchange-traded futures and options which have
standardised terms that cannot be changed. Farmers in Australia would primarily use commodity
swaps or forwards to hedge commodity price risk, as the swaps can be more closely tailored to
the needs of the producer compared to futures.

In managing the price risk of commodities, risk managers should always be mindful of basis risk.
This is especially true in the case of soft commodities as, for example, the grade of grain that the
farmer produces will depend on weather conditions and as a result may differ to the specification
of a standard futures contract being utilised in a hedge arrangement.

Basis risk arises when the hedge does not perfectly fix the price risk associated with the
commodity. Each hedge relationship should be carefully reviewed on construction to understand
the degree of basis risk remaining. While basis risk will frequently be minor compared to the
price risk faced, this will not always be the case. For example, farmers will usually have a force
majeure clause in their contracts in case their production fails, but such clauses are not replicated
in futures contracts and are another consideration for wholesalers in the industry.

Metals
Base metals MODULE 6
Base metals are non-ferrous industrial metals. The grouping includes copper, aluminium, lead,
nickel, tin and zinc.

Base metal prices have been extremely volatile in recent years and, given the variety of uses of
base metals in industry, this has had wide-ranging impacts. Base metal prices surged between
2003 and 2007, driven by low stockpiles of metals and strong demand from China and India,
and buying from investment funds. Prices fell sharply with the onset of the global financial crisis
in 2008 and, as shown in Figure 6.9, have since recovered to varying degrees.
 380 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Figure 6.9: London Metal Exchange base metal prices

USD/MT LME copper USD/MT LME aluminium

9 600 3 000
8 600 2 800
2 600
7 600
2 400
6 600 2 200
5 600 2 000
1 800
4 600
1 600
3 600 1 400
2 600 1 200
1 000
1 600
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

LME zinc LME nickel

USD/MT USD/MT

4 200
50 700
3 700
40 700
3 200

2 700 30 700

2 200
20 700
1 700
10 700
1 200

700 700
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Based on data from Index Mundi 2013a, ‘Crude oil (petroleum) price index’, accessed August 2013,
http://www.indexmundi.com/commodities/?commodity=petroleum-price-index&months=300.

The London Metals Exchange (LME) is the major futures exchange for the trading metals.
The exchange is a highly liquid market; in 2008 contracts to the equivalent value of USD 10 200
billion were traded with an average daily turnover of USD 40–45 billion. The LME offers both
exchange-traded futures and option contracts on base metals. In addition to base metals, the LME
also offers contracts on steel and plastics.

Base metals are also traded in the OTC market, where the miners and base metal consumers deal
directly with a financial institution rather than through an exchange. The majority of producers
and buyers tend to use the OTC market to hedge, as OTC derivatives such as swaps, forwards
and options can be tailored to the specific amounts, dates and prices they require as opposed to
exchange-traded futures and options which have standardised terms.

There is a common perception that base metals present greater challenges in relation to the
construction of viable hedging agreements due to their underlying volatility relative to other
metals. This perception is spurious and is probably a consequence of the practices of many major
mining companies. While many major mining companies continue to remain unhedged, this is not
MODULE 6

because of the difficulty associated with constructing viable hedge structures but rather with those
companies’ desire to remain unhedged. It may appear counterintuitive for a mining company to
remain unhedged, thereby choosing not to take offsetting positions designed to moderate the
price risk of their physical operations, but this approach is consistent with their desire to make their
company attractive to investors.
 Study guide | 381

Many investors consider mining companies to be similar to commodities and therefore,

by investing in those companies, they wish to be exposed to the commodity price risk as this
can act as a hedge against inflation (commodity prices tend to increase at the same rate or at
a greater rate than inflation). Hence, after consulting their investor base, many companies are
reluctant to hedge because of this investor desire to be exposed to the underlying volatility
associated with key industrial metal.

Despite this, given the potential for decline in the prices of key industrial metals, it may now
be commercially expedient for companies to reconsider their unhedged positions in pursuit of
more earnings certainty, or at least to implement a hedge strategy to protect their cash flows and
credit metrics if these are at risk. This is especially important to smaller companies with marginal
profitability and capital bases.

Bulks
Iron ore
Iron ore is the single largest exported resource commodity from Australia both in volume and
value and yet it is the least developed of the hedge markets. Originally there were few buyers
and sellers, and pricing was discovered based on annual negotiations between the mining and
importing companies. This worked reliably for some time but broke down when high prices
became entrenched and both buyers and sellers started looking at the spot market as a means
to set pricing. As iron ore, like many commodities, is subject to different specifications and spot
prices are set at different ports (China, India, Korea and Japan) it has been more difficult to
establish a liquid derivatives market. Furthermore, major mining companies have a no‑hedge
policy that reduces the opportunity to develop a deep liquid market. The different spot markets
and different grades can create basis risk for any company considering hedging iron ore,
which needs to be carefully considered. The standard derivative contract assumes a specific
grade of iron ore and a specific spot market (port of delivery) hence, to the extent either the
grade or spot price basis differs, basis risk arises.

Nevertheless, a swap market for iron ore is slowly developing. As this market develops
further, it will enable companies on both sides of the market to better manage their price and
counterparty risk. Furthermore, physical contracting terms will match the derivative market
pricing methodology to reduce basis risk. For example, the price in the physical contract may
settle by reference to the spot market on which derivatives are settled, and a set margin
may be established for grade variations.

Energy MODULE 6

Energy markets are those which deal with the buying and selling of energy. There are numerous
energy markets traded around the world. These include crude oil, natural gas, electricity,
carbon and renewable energy. Crude oil is the world’s most actively traded commodity and
the New York Mercantile Exchange (NYMEX) trades the most liquid crude oil futures contract,
known as light sweet crude (West Texas Intermediate or WTI). Light sweet crude is preferred by
refiners because of the low sulphur content over the relatively high yields of high value products
such as gasoline, diesel fuel, heating oil and jet fuel.
 382 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Figure 6.10: Crude oil

USD/Barrel
160

140

120

100

80

60

40

20

0
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Source: Based on data from Index Mundi 2013b, ‘Crude oil (petroleum) monthly’, accessed August
2013, http://www.indexmundi.com/commodities/?commodity=curde-oil&months=300.

Volatile crude oil prices have a significant impact on organisations and the global economy.
The airline industry was particularly hard hit by the rising oil price and subsequent economic
slowdown in recent years. The rising oil price resulted in massive cost increases for airlines at
a time when heavy competition and a softening economy limited their ability to raise ticket
prices. Hedging jet fuel prices is one method for airlines to reduce risk and potentially bolster
cash‑flow stability.

The energy market is subject to basis risk similar in a similar way to other commodity markets.
Airlines frequently hedge using crude oil futures, as this is a deep and long-term derivatives
market. However, airlines use jet fuel rather than the less refined crude oil product and therefore,
to the extent that the spot price of jet fuel does not move in the same fashion as the spot price of
crude oil, basis risk arises.

Likewise, transport companies in Australia are major consumers of diesel fuel, but the spot price
of diesel in Australia does not align perfectly with the spot price of diesel used in futures markets
offshore, so if transport companies were to hedge with offshore futures contracts, there would
be significant basis risk. In practice, transport companies tend to pass on fuel risk to customers
through a fuel levy.
MODULE 6

Precious metals
Precious metals include gold, silver, platinum and palladium. Because of its historical significance
in precious metals trading, the following section will focus on the gold market.

The gold market

The gold market is measured in troy ounces (for which the standard currency code is XAU) and
the price of gold is typically stated as the cost of one ounce in USD (e.g. XAU/USD 1400/oz,
translates as 1 oz of gold = USD 1400).
 Study guide | 383

Figure 6.11: USD gold prices 1984–2013

USD/oz
$1 800.00
$1 600.00
$1 400.00
$1 200.00
$1 000.00
$800.00
$600.00
$400.00
$200.00
$0.00
84 986 988 990 992 994 996 998 000 002 004 006 008 010 012 014
19 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2

Source: Based on data from T. McMahon 2013, ‘Historical crude oil table’, Inflation Data, 16 April,
accessed August 2013, http://inflationdata.com/Inflation/Inflation_Rate/Historical_Oil_Prices_Table.asp.

Demand for gold depends on changes in investment levels as well as physical manufacturing
demand.

Australia has been a significant world gold producer since the gold-rush days of the 1850s and is
still the second-largest producer of gold in the world, ranking behind South Africa and ahead of
the US and China.

While gold is mostly traded in USD, there is an active market that quotes AUD gold (XAU/AUD).
This is useful for Australian-based producers as they are able to transact and hedge in AUD terms
without the need to transact the gold price and FX separately. The AUD gold market is active in
spot, forwards, swaps and options, but is ultimately a function of the international price and the
price of the AUD.

Gold contango
Because there is such a large amount of gold held by central banks around the world, the rate at
which they lend the gold (known as the ‘gold lease rate’) is normally in the range of 0 per cent to
4 per cent. (Note: It is not an interest rate, but a lease rate.) Therefore, the gold market is usually
in contango. MODULE 6

Gold contango = Current cash interest rate – Gold lease rate

 384 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Case Study 6.6: XYZ Gold

The spot gold price has risen to AUD 1400 per ounce and XYZ Gold Mining decides to hedge
5000 ounces to be delivered in 12 months’ time.

The market is quoting the following rates:

Spot price = AUD 1400 per ounce.
Australian 12-month interest rate = 4%
12-month gold lease rate = 1%
Bank’s profit margin = 0.50%

XYZ Gold Mining advises its bullion bank that it wishes to sell 5000 ounces forward for 12 months at
the current market price (i.e. the forward rate).

The bank immediately borrows 5000 ounces of gold from a central bank (e.g. Reserve Bank of Australia)
and sells it into the spot market.

The bank raises 5000 × 1400 = AUD 7 000 000 cash and agrees to repay the gold in 12 months plus
gold lease-rate fees.

Lease fees payable to the central bank, AUD 7 000 000 × 1.0% = AUD 70 000

The bank invests the AUD 7 000 000 in the market, earning 4 per cent (AUD 7 000 000 × 4.0% =
AUD 280 000).

As a result of the bank earning more interest than it is paying in lease fees, the bank is able to pay
XYZ Gold Mining more than the AUD 1400 spot rate.

AUD
Amount raised selling 5000 oz 7 000 000
Plus interest earned 280 000
Less lease fee payable (70 000)
Less bank’s margin (35 000)
7 175 000

Net amount payable to XYZ Gold Mining AUD 7 175 000.

So XYZ Gold Mining delivers 5000 ounces of gold in 12 months’ time and receives AUD 7 175 000. This is
an effective gold price of AUD 1435 (AUD 7 175 000 / 5000), compared to the spot price of AUD 1400.

➤➤Question 6.8
(a) Briefly explain the terms ‘contango’ and ‘backwardation’.
MODULE 6

(b) Explain why the gold price is normally in contango.

Gold risk management

The best practice approach to managing gold price risk is basically the same approach used for
managing FX risk. The risk management approach that is adopted by a gold producer should
be determined by the producer’s risk objectives and risks inherent in the business.

Australian-based gold producers are subject to sharp market fluctuations in both the gold
price and FX rates. For an Australian gold producer, a falling gold price, a rising AUD and rising
production costs would reduce earnings if these risks were left unhedged.
 Study guide | 385

The approach adopted by gold producers to managing risk and the amount of hedging that is
undertaken will depend on:
• production costs;
• profit margins;
• debt repayment schedules; and
• the amount of gold reserves.

Since 1999, the trend amongst gold producers has been to reduce the amount of hedging they
undertake. Some producers have even been de-hedging. The process of de-hedging is essentially
to buy back the gold that was previously hedged. The purpose of de-hedging is to increase the
producer’s exposure to movements in the spot gold price.

This recent trend of reduced hedging and increasing exposure to the spot gold price has been
driven by two main factors:
• Since 1999 the USD gold price has been rising and gold producers and their shareholders
have wanted a greater exposure to this rising price.
• Several hedging disasters have made gold hedging less fashionable (e.g. Pasminco—
see Case Study 6.8).

Despite this recent trend, managing gold price risk and FX risk remains an important consideration
for gold producers. Should the gold price fall, producers would have their margins reduced.
Buying gold put options is one risk management approach that enables producers to benefit from
a rising gold price while establishing a floor on their sales.

Gold forward contracts

Gold forward contracts are contracts whereby the gold producer sells gold in exchange for AUD
with an approved counterparty at a fixed forward price for a fixed future date. The spot gold
price is adjusted by the prevailing differential between interest rates and the gold lease rate
for the term to maturity. Gold forward contracts give the producer a known forward gold price,
regardless of movements in the spot gold price.

Gold options
Alternatively, a gold producer could buy a gold put option (AUD call). A bought gold put
(AUD call) option provides the gold producer with the right, but not the obligation, to sell gold
and buy AUD for an agreed number of ounces at an agreed strike price at a future date. The gold
producer is guaranteed a worst-case gold price with unlimited participation in favourable gold
price movements for the cost of an up-front premium. Buying gold put options is an attractive
strategy which enables the producer to protect against a fall in the gold price while still
participating in favourable gold price moves. MODULE 6

Gold collar
Alternatively, the producer could enter into a nil-premium collar. This structure is a combination
of options whereby the gold producer purchases a gold put and simultaneously sells a gold call
to offset the cost of the put, thereby creating a collar to achieve a nil premium. A collar:
• carries a delivery obligation because of the gold call the producer has sold;
• provides cheap insurance, while allowing some participation in favourable movements
in the gold price; and
• fully eliminates risk of adverse gold price movements to the level of the bought put.
 386 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Case Study 6.7: Midas Gold

An Australian gold producer, Midas Gold, expects to produce 25 000 ounces of gold in three months’
time. The AUD gold price has risen sharply in recent months and is currently trading at AUD 1400 per
ounce, well above the producer’s cost of production of AUD 1000 per ounce. The producer decides
to enter into a forward gold sale to protect the profit margin.

Before hedging, the producer is exposed to a decline in the AUD gold price which would reduce the
profit margin.

Impact of fluctuations in the AUD gold price

AUD gold price AUD revenue per 25 000 ounces

1200 30 000 000

1250 31 250 000

1300 32 500 000

1350 33 750 000

1400 35 000 000

1450 36 250 000

1500 37 500 000

1550 38 750 000

1600 40 000 000

The table above shows that the revenue generated by the producer declines as the AUD gold price falls.

To hedge this risk, the producer can enter into a three-month forward contract to sell gold at
AUD 1435 per ounce and lock in AUD revenue of 25 000 × 1435 = AUD 35 875 000. Once the forward
contract has been entered into, the producer does not need to worry about movements in the AUD gold
price, as shown in the table below.

Impact of forward gold contract on fluctuations in the AUD gold price

AUD gold price AUD revenue per 25 000 ounces

1200 35 875 000

1250 35 875 000

1300 35 875 000

1350 35 875 000

MODULE 6

1400 35 875 000

1450 35 875 000

1500 35 875 000

1550 35 875 000

1600 35 875 000

This table shows that once the producer has entered into the gold forward, the AUD revenue is fixed
at AUD 35 875 000, regardless of movements in the spot price.
 Study guide | 387

➤➤Question 6.9
An Australian gold producer expects to produce 50 000 ounces of gold in six months’ time.
The current spot gold price is AUD 1400 per ounce which is well above the company’s cost of
production of AUD 1275 per ounce. The producer is keen to protect this margin, but would also
like to benefit should the AUD gold price continue to rise. Which of the following risk management
strategies would you recommend?
(a) The producer to enter into a contract to sell gold six months forward at AUD 1440.
(b) The producer to buy a gold put (AUD call) with a strike of AUD 1440, expiring in six‑months’
time at a cost of AUD 40 per ounce.
Calculate the producer’s profit margin under both strategies, assuming the gold price in six‑months’
time is: (i) AUD 1300 or (ii) AUD 1600 per ounce.

Case Study 6.8: Pasminco Ltd

The Pasminco experience is an excellent example of the potentially disastrous consequences to
a company of misjudging the impact of currency movements and commodity exposures.

Pasminco Ltd was a major Australian mining company and one of the largest producers of zinc and
lead in the world. In September 2001, the company was placed in voluntary administration with debts in
excess of AUD 3.4 billion.

In a statement to the 2001 and 2002 joint annual general meetings, John Sparks, deed administrator
and chairman of the meetings, stated that Pasminco’s financial position was largely a result of the
substantial decline in the zinc price, but also a combination of the following additional factors:
• the size of Pasminco’s debt burden;
• the acquisition and subsequent underperformance of the Savage assets;
• Pasminco’s hedge book; and
• inadequate management information systems.

One of the main reasons for Pasminco’s financial demise can be directly linked to the company’s FX risk
management practices. In 2000–01, the company implemented a hedging strategy which involved
locking in an AUD/USD exchange rate of between 0.6500 and 0.6800 in the belief that the AUD
would appreciate. Unfortunately for Pasminco, the value of the AUD fell to as low as 0.4800 during
2000–01. Since Pasminco had entered into committed hedging, it was obligated to deliver USD to its
counterparties at rates between 0.6500 and 0.6800.

At the same time as the AUD was falling, so too was the zinc price. Pasminco had not hedged its
exposure to the zinc price, which meant it was not receiving enough USD to deliver against its hedges.
This forced Pasminco into the market to buy USD to deliver against the hedging, which resulted in
large currency losses.
MODULE 6
The problems at Pasminco could have been avoided if the company had implemented a best practice
risk management framework. That framework could have ensured that the hedging instruments used
by Pasminco matched the firm’s underlying exposure. The decision to hedge only the FX risk and
not the commodity risk left the firm particularly exposed. Scenario or cash-flow-at-risk analysis would
have highlighted Pasminco’s flawed hedging approach.
 388 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Case Study 6.9: Perseverance Corporation Ltd

Perseverance Corporation Ltd (Perseverance) was an Australian-based gold producer operating
the Fosterville Gold Mine, 20 kilometres east of Bendigo in Victoria. In March 2006, Perseverance
reported a AUD 31.875 million loss for the six months to 31 December 2005. While the company
reported a AUD 5.274 million operating loss, the majority of the loss, AUD 25.187 million, represented
changes during the six-month period in the mark-to-market value of the company’s gold hedge book.
This negative change in the mark-to-market value of the hedge book was required to go through the
income statement (rather than being shown in the balance sheet) because hedging practices adopted
by Perseverance were not documented in accordance with the requirements of IAS 39. This is a good
example of a company implementing hedging strategies that are common within the gold industry
and which represent good financial risk management, but failing to achieve hedge accounting because
of a relatively minor breach of the documentation requirements of IAS 39. This minor breach resulted
in the AUD 25.187 million increase in the reported loss.

This case demonstrates that companies not only need to adopt risk management practices that protect
the financial value of the business, but must also comply with all aspects of IAS 39 if they want to achieve
hedge accounting. Failure to achieve hedge accounting can have a significant impact on the reported
profit or loss of a business, as shown in the case of Perseverance.

Candidates should obtain a copy of the ‘Clarification for shareholders’ notice issued by Perseverance
on 1 March 2006. In this notice, the chairman (John Quinn) explains to shareholders the reasons for
the reported loss. The chairman also discusses the accounting standard and some of its weaknesses
and limitations. Mr Quinn’s comments regarding the inflexibility of the new accounting standard are
shared by many professionals within the financial risk management industry. Companies must comply
with all aspects of the standard if they wish to achieve hedge accounting.

Copies of the ‘Clarification for shareholders’ notice can be found at the following website:
http://www.asx.com.au//asxpdf/20060301/pdf/3vnmkxcbw3vnp.pdf.

Northgate Minerals Corporation completed the acquisition of Perseverance Corporation Ltd on

10 February 2008.

Recent trends in foreign exchange and commodity

risk management
Quantitative approach to financial risks
As computing power increases and treasury systems improve, there have been significant
advances in the sophistication of quantifying risks. This has meant that many of the risk measures
and techniques that previously were isolated to major financial institutions and trading houses are
now being used by smaller companies. Typical measures being introduced include Monte Carlo
analysis, earnings at risk and cash flow at risk.
MODULE 6

Monte Carlo analysis is a useful decision-making tool as it presents large numbers of simulations
under different market conditions (e.g. it will randomly simulate exchange rates) to assist in
highlighting any outcomes that may not align with the risk appetite of the board. By providing a
picture of possible outcomes, it may also assist the board in refining its risk appetite and thereby
choosing an appropriate hedge strategy.

Figure 6.12 reflects more than 3000 random simulations of possible exchange rates. Random
simulations are chosen based on a normal distribution, given the unreliability of forecast
exchange rates. It illustrates the probability (or frequency) of different outcomes, utilising four of
the five hedge strategies shown in Table 6.4. Approach 1 is the unhedged scenario, Approach 2
utilises an FEC, Approach 3 is a down-sided protection strategy and Approach 5 is the collar
strategy. In respect of Approach 2, all simulations gave the one profit result, which has been cut
at 1200 (frequency of outcome) to highlight the distribution of the other strategies.
 Study guide | 389

Figure 6.12: Monte Carlo analysis of Example 6.3

1200

1000
Frequency of outcome

800

600 Approach 1
Approach 2
400
Approach 3
200 Approach 5

0
–44 556
91 546
227 648
363 750
499 852
635 954
772 056
908 158
1 044 260
1 180 362
1 316 463
1 452 565
1 588 667
1 724 769
1 860 871
1 996 973
2 133 075
2 269 177
2 405 279
2 541 381
2 677 483
AUD profit on sale

From this distribution, we can determine the mean and standard deviation and the degree
of confidence of achieving certain outcomes for given hedge strategies. Likewise, we could
use this to determine the cash flow at risk (CFaR), which is defined as the cash flow expected
under adverse outcomes with a degree of confidence (normally 95% over a given time frame).
Alternatively, if accounting measures are utilised, earnings at risk (EaR) might also be calculated.

The new qualitative measures are a sophisticated way of considering alternative strategies
and can be consistently utilised across the entire business. As with any financial modelling,
robust controls must always be put in place over the reliability of underlying data, mathematical
accuracy of the model and reasonableness of the assumptions.

Merchant banks and trading companies

An increasingly popular approach to improving returns on commodities is the practice of
investing in metal warehousing. Metal warehousing is the provision of warehousing services
in support of commodity transaction settlement and trade. Organisations such as Goldman
Sachs, Louis Dreyfus Commodities DV, Trafigura and Glencore have recently become significant
metal warehousing investors. While no company has explicitly stated its reasons for pursuing
opportunities in metals storage, the reasons are evident.

If, for example, a commodity is in contango, then the warehouse-owning entity is in a prime
position to generate profit from its involvement. Warehousing can also be seen as a hedge-like
MODULE 6

approach to offsetting a position taken within the market. Moreover, the companies that have
invested in warehousing can access opportunities not available to companies that are not in
possession of metals warehousing facilities. Companies can take advantage of the differentials
in on-market traded and off-market traded commodities, and readily adjust to changes in the
structure of metals futures prices.
 390 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Review
The focus in Module 6 has been the strategic FX risk management by organisations. The main
issues influencing exchange rates were briefly discussed, as were some of the common
misconceptions about currencies.

A five-stage financial risk management program was then outlined—paralleling the approach
used for interest rate risk management in Module 5. This was followed by a set of worked
examples covering importers and exporters.

Commodity risk was then introduced, with a special emphasis on gold risk management.

The overall emphasis has been on managing underlying risks and, where possible, the avoidance
of forecasting and speculation.
MODULE 6
 Suggested answers | 391

Suggested answers
Suggested answers

Question 6.1
(a) The quote of AUD/USD 0.9450 / 70 is the bank’s two-way bid and offer quote. It can be
extended to become AUD/USD 0.9450 – 0.9470. The bank will always look to buy AUD low
(0.9450) and sell AUD high (0.9470). The difference between this buy and sell quote is the
bank’s spread or margin.

At 0.9450, the bank will buy AUD (and sell USD). At 0.9470, the bank will sell AUD (and buy
USD). The importer will need to sell AUD to the bank and buy USD to pay for the goods it is
importing. Therefore, the importer will sell its AUD at the rate the bank is bidding to buy AUD
(and sell USD), which is 0.9450.

(b) The importer will pay USD 1 000 000 / 0.9450 = AUD 1 058 201.06.

Question 6.2
First, experts are wary of any forecast. This view is supported in a speech to the 21st Annual
Monetary Conference in Washington in 2003, made by US Federal Reserve Chairman Alan MODULE 6
Greenspan. He said:
My experience is that exchange markets have become so efficient that virtually all relevant
information is embedded almost instantaneously in exchange rates to the point that anticipating
movements in major currencies is rarely possible. Despite extensive efforts on the part of analysts,
to my knowledge, no model projecting directional movements in exchange rates is significantly
superior to tossing a coin.

Therefore, given the unpredictable nature of currency movements, organisations should not rely
on currency forecasts when making risk management decisions. Foreign exchange (FX) decisions
should be made in accordance with the risk management framework outlined in this module.
 392 | FOREIGN EXCHANGE AND COMMODITY RISK MANAGEMENT

Second, banks such as ABC Bank issue forecasts, but do not normally act upon them.
Banks generate a margin by buying and selling FX; they do not act as currency speculators.

Third, currency prices are relative prices, not absolute prices. Therefore, if Australian interest
rates rise (or are expected to rise) and US rates also rise (or are expected to rise), the relative
differential between the two could be nil and so there is no effect on currency prices.

Question 6.3
The loan would create both transaction and translation risks. Payment of the interest each year
will create a transaction exposure and if the AUD weakens, this may cost more than the company
budgeted for. The loan would also be on the books as a liability and the revaluation of this loan
each year into local currency will highlight the translation exposure under IAS 39.

Question 6.4
The forward price is not a forecast. It is based on market reference rates at a point in time.
The forward rate formula and Example 4.4 (in Module 4) highlight how the forward rate
is calculated.

Forward rate = [0.9000 × (1 + (0.04 × 90 / 360)] / [1 + (0.06 × 90 / 365)] = 0.8957

Question 6.5
(a) The company is exposed to transaction risk. Since the company has contracted to purchase
the equipment, the exposure is considered a committed exposure.

(b) If the AUD fell to 0.8000 in six months’ time, the AUD cost of the equipment would increase.

(c) (i) USD 2 000 000 / 0.8000 = AUD 2 500 000.00.

(ii) USD 2 000 000 / 0.8950 = AUD 2 234 636.87.
(iii) The effective exchange rate would be 0.8710 (strike price – option premium).
Therefore, the AUD cost would be USD 2 000 000 / 0.8710 = AUD 2 296 211.25.

(d) The company would purchase the AUD put to protect against a decline in the AUD while still
MODULE 6

being able to participate in any AUD rise.

Question 6.6
(a) If the AUD was trading at 0.9300, the exporter would exercise the option and purchase
AUD at 0.9000.

(b) The effective exchange rate would be 0.9090 (strike rate + option premium).
 Suggested answers | 393

Question 6.7
Best practice risk management recommends that the exporter should hedge this exposure
with the bought call option. Since the sales are uncommitted and the forecasts are not reliable,
best practice risk management recommends that this type of exposure be hedged with an
instrument that does not carry a delivery obligation. If the organisation was to hedge with
an FEC and the sales did not occur, it would still be required to deliver the USD when
the contract matured.

Question 6.8
(a) Contango occurs when the forward price of a commodity is higher than the current spot price.
Backwardation occurs when the forward price is lower than the current spot price.

(b) The gold price is normally in contango because interest rates are normally higher than gold
lease rates. Gold lease rates are kept low because of the large amount of gold the central
banks lend into the market.

Question 6.9
The producer would purchase the gold put option. This gives the producer the right but not the
obligation to sell gold at AUD 1440. If the AUD gold price rose to AUD 1600, the producer would
allow the option to lapse and sell the gold in the spot market at AUD 1600 per ounce.

With the gold forward, the gold price is locked in at AUD 1440 regardless of movements in the
spot price. Therefore, the producer’s margin is AUD 165 per ounce (AUD 1440 – AUD 1275)
when the spot gold price is at AUD 1300 or AUD 1600.

With the bought gold put option:

(i) at AUD 1300, the producer would exercise the AUD 1440 call option, giving an effective
AUD gold price of AUD 1400 per ounce (strike price – option premium). Therefore,
the producer’s margin would be AUD 125 per ounce (AUD 1400 – AUD 1275); or
(ii) at AUD 1600, the producer would allow the option to expire worthless and sell the gold
on the spot market at AUD 1600 per ounce. The effective gold price would be AUD 1560
(spot price – option premium). Therefore, the gold producer’s margin would be AUD 285
per ounce.
MODULE 6
MODULE 6
 References | 395

References
References

Greenspan, A. 2003, ‘Remarks by Chairman Alan Greenspan at the 21st Annual Meeting
Conference’, Washington DC, 20 November, accessed October 2013, http://www.federalreserve.
gov/boarddocs/speeches/2003/20031120/default.htm.

Harding, D. 2004, Briefing to the Australian Institute of Company Directors, 14 October,

Freehills, Sydney.

Index Mundi 2013a, ‘Crude oil (petroleum) price index’, accessed August 2013,
http://www.indexmundi.com/commodities/?commodity=petroleum-price-index&months=300.

Index Mundi 2013b, ‘Crude oil (petroleum) monthly’, accessed August 2013,
http://www.indexmundi.com/commodities/?commodity=curde-oil&months=300.

London Metals Exchange 2013, ‘LME aluminium’ (2 August), accessed August 2013,
http://www.lme.com/metals/non-ferrous/aluminium.

McMahon, T. 2013, ‘Historical crude oil table’, Inflation Data, 16 April, accessed August 2013,
http://inflationdata.com/Inflation/Inflation_Rate/Historical_Oil_Prices_Table.asp.

Trading Charts 2013, ‘Light crude oil’ (2 August), accessed August 2013, http://futures. MODULE 6
tradingcharts.com/marketquotes/CL_.htm.

Reserve Bank of Australia 2013, ‘Exchange rate data’, accessed August 2013, http://www.rba.gov.
au/statistics/hist-exchange-rates/.
MODULE 6
 FINANCIAL RISK MANAGEMENT

Module 7
ACCOUNTING FOR DERIVATIVES AND
HEDGE RELATIONSHIPS
JOHN KIDD
 398 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Contents
Preview 399
Introduction
Objectives
Teaching materials

Part A: Accounting concepts 401

Introduction 401
IAS 39 Financial Instruments: Recognition and Measurement

Part B: Hedge accounting 414

Introduction 414
What is hedging?
Importance of accounting rules in relation to hedging
What qualifies as a hedge instrument?
The hedged item
The hedged risks
Cash flow hedge
Fair value hedge
Net investments in a foreign operation
Hedge effectiveness
Hedge documentation
Foreign currency transactions
New hedge accounting model under IFRS 9

Review 454

Appendix 455
Appendix 7.1 455

Suggested answers 461

MODULE 7
 Study guide | 399

Module 7:
Accounting for derivatives
and hedge relationships
Study guide

Preview
Introduction
This module discusses the requirements of IAS 39, IFRS 7 and IAS 32 as they pertain to
derivatives and hedge relationships. The interaction between IAS 21 and IAS 39 regarding
foreign exchange hedge relationships is also included. The approach to accounting for
derivatives and hedge relationships is covered in Part A. Part B focuses on the more practical
aspects of hedge accounting and explores in further detail some of the complexities that arise.
In addition, this section introduces the new hedge accounting model in IFRS 9.

Objectives
By the end of this module you should be able to:
• explain the definition of a derivative and an embedded derivative under IAS 39;
• explain the accounting classification as it relates to derivatives and hedged items;
• explain hedging and what qualifies as a hedge instrument;
• explain the various rules for hedge accounting under IAS 39;
• discuss the three different types of hedges;
• account for cash flow, fair value and net investment hedges;
• assess and measure the effectiveness of a hedge;
• outline the documentation required under IAS 39; and
MODULE 7

• explain the key changes to the rules for hedge accounting introduced under IFRS 9.
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Teaching materials
• International Financial Reporting Standards (IFRS)
IFRS 7 Financial Instruments: Disclosures
IFRS 9 Financial Instruments
IFRS 13 Fair Value Measurement
IAS 21 The Effects of Changes in Foreign Exchange Rates
IAS 32 Financial Instruments: Presentation
IAS 39 Financial Instruments: Recognition and Measurement
IAS 39 Financial Instruments: Recognition and Measurement—Implementation Guidance
(January 2010)

• A link to a glossary of financial instruments and the terms used to describe activities and
types of financial instruments is: http://www.traderslog.com/financial-instruments.
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Part A: Accounting concepts

Introduction
It wasn’t until 2005 that an accounting standard on financial instruments was released by
the IASB. This was due to the difficulty of members within the profession agreeing to such a
standard. In fact, the guidance for many years simply stated that financial statements explain
how companies account for different financial instruments. One specific area of difficulty was
accounting for derivatives; most organisations that used derivatives for hedging at the time did
not record those derivatives in their financial statements on the basis that, under historical cost
measurement, derivatives did not have an initial cost and hence did not require recognition
until they were settled. This meant that derivatives (potentially large assets and liabilities) were
not recorded in the accounts. However, after a number of significant corporate losses involving
the use of derivatives, the accounting profession was challenged by investors to take a strict
accounting stand on the topic.

It was finally agreed that derivatives should be recorded in the statement of financial position as
an asset or liability at fair value, as this was the most appropriate measure of the derivative’s value
and reflected the most relevant and reliable information to investors. Further, it was decided that
the changes in the value of derivatives should be reflected in a reserve account (i.e. equity in the
statement of financial position) or the profit and loss (i.e. statement of profit and loss or other
comprehensive income), depending on whether there was a hedge relationship. The objective
was to record derivatives in the statement of financial position at fair value, while simultaneously
achieving an historical cost accounting result in the profit and loss. This is called a mixed
measurement approach (i.e. part fair value and part historical cost),

Unfortunately, to achieve this outcome, a lot of complexity has been created in this area of
financial accounting. It has required the accounting standards to define what a derivative is,
what a hedge is and how its effectiveness is measured. These are all matters that are more
finance related than accounting related, and require accountants to be able to understand and
value derivatives. This introduces a lot of complexity to accounting but should result in fewer
derivative-related corporate losses, as accountants gain a better understanding of derivatives
and how they are being used.

From 1 January 2005, Australia adopted International Financial Reporting Standards (IFRSs)
and the Australian Accounting Standards Board (AASB) issued Australian equivalents. The
following standards deal with financial instruments: IFRS 7 Financial Instruments: Disclosures,
IAS 32 Financial Instruments: Presentation, IAS 39 Financial Instruments: Recognition and
Measurement, and IAS 21 The Effects of Changes in Foreign Exchange Rates. In addition, IFRS 9
Financial Instruments and IFRS 13 Fair Value Measurement have been released.

In 2009, the first phase of IFRS 9 Financial Instruments was released. This represented ‘phase 1’
of a complete rewrite of accounting standards on financial instruments to replace IAS 39. IAS 39
is considered by many, including the Group of Twenty (G20), to be overly complex and difficult
to apply. The International Accounting Standard Board’s (IASB’s) project sought to rectify these
difficulties by replacing IAS 39 with the release of IFRS 9. Phase 2 is a work in progress and deals
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with impairment of financial instruments, changing from the current ‘incurred loss’ model under
IAS 39 to an ‘expected loss’ model under IFRS 9. Phase 3 deals with hedge accounting and is
complete except for macro hedging.
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The ‘simplification’ introduced by the new standard will see some changes in accounting for
financial assets and liabilities. The new standard has a mandatory commencement date of
1 January 2018 and early adoption is available. This module does not cover phase 1 or 2 of
IFRS 9.

In respect of phase 3, the existing hedge accounting requirements in IAS 39 Financial

Instruments: Recognition and Measurement are often considered by users and preparers of
financial statements to be complex and not reflective of an entity’s risk management activities;
nor do they reflect the extent to which those activities are successful in meeting the entity’s
risk management objectives. Many also find the requirements in IAS 39 excessively rule-based,
resulting in arbitrary outcomes. Phase 3 has created a new hedge accounting model following
a simplified, objective-based approach to hedge accounting and aligning it with an entity’s risk
management processes. This project is split into two parts: general hedge accounting (finalised
in 2013; key changes in hedge accounting are listed at the end of this module); and macro hedge
accounting (a work in progress).

In 2013, IFRS 13 Fair Value Measurement was introduced and covers the approach to determining
fair value. The standard applies to all entities (not just financial institutions) and to all financial
instruments.

Derivatives, as a type of financial instrument, are therefore captured by the IFRSs adopted
by Australia. To the extent that a derivative (e.g. an option) is the hedging instrument in a
hedge relationship, the hedged item (e.g. an investment asset) is also captured by the hedge
accounting provisions of IAS 39 and certain disclosure requirements under IFRS 7. This module
incorporates the derivative, embedded derivative and hedge accounting elements of IAS 39 as
well as their interaction with IAS 21, which occurs within certain foreign exchange rate related
hedge relationships. This module also introduces the changes to hedge accounting as a result of
phase 3 of IFRS 9.

IAS 39 Financial Instruments: Recognition and Measurement

What is a derivative?
A derivative is a financial instrument whose value depends on the value of another instrument
(referred to as the ‘underlying’). Small changes to the value of the underlying can cause large
swings in a derivative’s value. As such, the measurement of derivatives is complex in that the
same instrument can switch from being a financial liability (when it has a negative value) to a
financial asset (when it has a positive value) while being held by the same entity.

Derivative instruments include forwards, futures, swaps and options, which were discussed in
detail in Module 4.

Definition of a derivative under IAS 39

The definition of a derivative as an accounting concept is very important under IAS 39, as all
derivatives must be fair valued and recorded on the balance sheet of companies. The change in
fair value of a derivative is recorded directly to the profit and loss unless the derivative is part of a
qualifying hedge relationship.
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IAS 39 defines a derivative as follows:

A derivative is a financial instrument … with all three of the following characteristics:
(a) its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or other variable, provided in the case of a non-financial variable that the variable is not
specific to a party to the contract (sometimes called the ‘underlying’);
(b) it requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors; and
(c) it is settled at a future date (IAS 39.9).

Table 7.1 provides examples of contracts that normally qualify as derivatives under IAS 39.

Table 7.1: Common derivatives

Main pricing–settlement variable

Type of contract (underlying variable)

Interest rate swap Interest rates

Forward exchange contracts (FECs) Foreign exchange rates
Commodity swap Commodity prices
Purchased or written currency option (call or put) Foreign exchange rates

The list in Table 7.1 is not exhaustive. Any contract that has the three characteristics in the
definition above may be a derivative. Moreover, even if an instrument meets the definition
of a derivative, special provisions of IAS 39 may apply to exclude it from the scope of IAS 39.
For example:
• employers’ rights and obligations under employee benefit plans, to which IAS 19 Employee
Benefits applies;
• contracts to buy or sell a non-financial item (e.g. gold) that were entered into and continue to
be held for the purpose of receipt or delivery of a non-financial item in accordance with the
entity’s expected purchase, sale or usage requirements (see IAS 39.5 and IAS 39.AG10); or
• a contract settled in an entity’s own shares (see IAS 32.21–32.24).

Therefore, an entity must evaluate each contract to determine whether: (a) the characteristics of
a derivative are present; and (b) whether special provisions apply to exclude it from the standard.
A derivative can also form part of a financial instrument or other contractual arrangement
frequently referred to as a host contract (e.g. a sales contract with a consumer price index (CPI)
adjustment clause). This type of derivative is referred to as an embedded derivative.

Derivative financial instruments are also discussed in Module 5 ‘Financial instruments’ of the
CPA Program subject ‘Financial Reporting’.

Accounting for a derivative

It is required that derivatives be recorded at fair value at inception with subsequent fair value
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changes recorded to profit or loss, unless they are in a qualifying hedge relationship—in which
case they will be recorded according to the hedge accounting rules in IAS 39.

The interaction of financial instrument classification and derivatives is outlined in Figure 7.1.
In particular, if hedge accounting does not apply, the derivative is classified as held for trading.
 404 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Figure 7.1: Accounting classification under IAS 39

Derivative Financial asset Financial liability

Available for Held to Loans and

Derivatives at Assets at Liabilities at Liabilities at
sale at maturity at receivable at
fair value fair value fair value amortised cost
fair value amortised cost amortised cost

Accounting

N Fair value Fair value Amortised Amortised Fair value Amortised

Hedge? to profit changes cost subject cost subject to profit cost
and loss to equity to impairment to impairment and loss
subject to
Y
impairment

Cash flow
See hedge
Net investment accounting
section

Fair value

Fair value
Guidance for measuring the fair value of financial instruments is included in IFRS 13 Fair Value
Measurement.

The principal objective of IFRS 13 in relation to financial instruments is similar to that in IAS 39;
however, the definition of fair value has been changed, resulting in differences (see the
definitions below).

IAS 39 IFRS 13

‘Fair value’ is the amount for which an asset could ‘Fair value’ is the price that would be received
be exchanged, or a liability settled, between to sell an asset or paid to transfer a liability in an
knowledgeable and willing parties in an arm’s-length orderly transaction between market participants at
transaction. the measurement date.

In respect of derivatives, the change in definition requires counterparty credit risk to be

considered in the valuation of a derivative, both when the derivative is in an asset (i.e. positive
value) and in a liability position (i.e. negative value). Previously, under IAS 39, this was typically
only factored into asset positions. As a result, when a derivative is in a liability position, the
company must now capture the impact of its own ‘credit risk’ in the fair value of the derivative.
For example, a notional gain or loss on a forward exchange contract in 12 months will be
discounted by the risk-free rate plus a credit margin. There are more sophisticated ways of
measuring the impact of credit on derivative fair values but they are beyond the scope of this
module. When the contract is in a gain position, the credit margin will be the counterparty’s
credit margin, and when the contract is in a loss position, the credit margin will be the company’s
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own credit margin.

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Note that the purpose of this module is to provide a high-level understanding of derivative
valuations to assist with understanding the accounting entries: it is not intended to cover
valuation of derivatives in detail. The valuation of derivatives is a complex, specialist area, so the
fair values computed in this module have not included credit margins in the discount rate.

➤➤Question 7.1
Assume that a CFO is surprised to learn from the auditors that the company must now adjust for
its own credit risk in valuing the derivatives held by the company, which are in a liability position.
Explain to the CFO whether the auditors are correct and, if so, why.

Embedded derivatives
What is an embedded derivative?
A derivative can form part of a financial instrument or other contractual arrangement frequently
referred to as a host contract. The terminology for assessing the accounting treatment of
an embedded derivative is summarised in Table 7.2. The contractual arrangement itself may
involve the purchase or supply of non-financial items including services. Often, clauses within the
contractual agreement meet the definition of a derivative. Such a derivative is an ‘embedded
derivative’. Hence an embedded derivative is a component of a hybrid instrument that also
includes a non-derivative host contract.

Table 7.2: Embedded derivative terminology

Component Terminology

Derivative Embedded derivative

Non-derivative Host contract

Total Hybrid instrument

Derivatives are inherently highly leveraged financial instruments and will thus change the
risk profile of the organisations that use contracts with embedded derivatives. For example,
a contract to purchase a machine in AUD can expose the company to foreign exchange
movements if it includes a rise and fall clause for foreign exchange rates. IAS 39 has been
written to ensure that derivatives embedded in host contracts, either deliberately through
financial engineering or through commercial negotiations (even if inadvertently), are identified
and accounted for separately as derivatives unless they are closely related to the host contract.
A host contract can take any form, including a sale or purchase agreement. Many contracts have
embedded derivatives, which include repricing clauses, consumer price index (CPI) adjustment
clauses and currency adjustment clauses.

After identifying an embedded derivative, one must determine whether it needs to be separated
and fair valued under IAS 39. Not all embedded derivatives need to be separated from the host
contract. Those that must be separated are accounted for in the same manner as a stand-alone
derivative, which is to value them at fair value with gains and losses recognised in the profit and
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loss statement, unless they too can be designated to be in a hedge relationship.

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Do embedded derivatives need to be separated?

The process of identifying embedded derivatives and determining whether they need to be
separated is resolved by the answers to the following questions:
• Is the host contract measured at fair value through profit or loss?
• Does it meet the definition of a derivative on a stand-alone basis?
• Is it clearly and closely related to the host contract?

The process is summarised in Figure 7.2.

Figure 7.2: Identifying embedded derivatives

Separate accounting
Is the host No Would it be Yes Is it closely No
contract carried a derivative if it was related to the
at fair value? free-standing? host contract?

Yes No Yes

No separate accounting under IAS 39

Step 1: Is the host contract fair valued?

If a host contract is already fair valued, and movements in fair value are reflected in the income
statement, there is no need to separate the embedded derivative. The value of the embedded
derivative will already be reflected in the value of the host contract.

Step 2: Is the embedded derivative really a derivative?

The next question is whether the potential embedded derivative that has been identified meets
the definition of a derivative on its own. For example, a CPI clause in a lease agreement would
be regarded as an embedded derivative as it satisfies the three characteristics of the accounting
definition of a derivative.

Step 3: Is the embedded derivative closely related to the host contract?

Finally, you do not need to separate the embedded derivative where it is closely related to
the host contract. Assessing whether it is closely related requires an analysis of the economic
characteristics and risks of the host contract to determine whether the embedded derivative
changes the nature of the risks involved in the host contract.

If an embedded derivative is not closely related to the host contract, it must be separated from
the host contract and fair valued.
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Identifying characteristics in embedded derivatives

Some characteristics to look for in host contracts to identify embedded derivatives include
the following:
• foreign exchange adjustment clauses (i.e. adjustments based on movements in foreign
exchange rates);
• price adjustments that have no relation to the host contract—for example, an aluminium
price adjustment in a supply agreement for electricity; and
• volume options on commodity contracts (i.e. an option to change the size of the contract)
where the underlying commodity is readily convertible to cash.

Special exceptions provided by the standard

The standard does specifically exempt certain embedded derivatives from being separated
where the economic characteristics and risks of the embedded derivative are closely related to
those of the host contract. The embedded derivative is therefore not separately accounted for
where it is closely related to the host contract. Examples include the following.

(a) Where the underlying is an interest rate that can change the amount of interest that would
otherwise be paid or received on an interest-bearing host debt instrument, provided that
(i) the combined instrument can be settled in such a way that the holder would not recover
substantially all of its recognised investment; or
(ii) the embedded derivative does not at least double the holder’s initial rate of return on the
host contract and does not result in a rate of return that is at least twice what the market
return would be for a contract with the same terms as the host contract.

(b) Where the underlying is an interest rate on a debt instrument and the embedded derivative is
a floor or cap on the interest rate, provided that
(i) the cap is at or above the market rate of interest and the floor is at or below the market
rate of interest when the instrument is issued; and
(ii) the cap or floor is not leveraged in relation to the host debt instrument (i.e. the cap
or floor rate does not move by more than the change in the interest rate on the debt
instrument.

(c) Where the embedded derivative is a foreign currency derivative for a non-financial
instrument, provided it is not leveraged, does not contain an option feature and requires
payments denominated in one of the following currencies:
(i) the functional currency of any substantial party to the contract;
(ii) the currency in which the price of the related good or service that is acquired or delivered
is routinely denominated in commercial transactions around the world (such as the USD
for crude oil transactions);
(iii) a currency that is commonly used in contracts to purchase or sell non-financial items in
the economic environment in which the transaction takes place (e.g. a relatively stable
and liquid currency that is commonly used in local business transactions or external
trade)—for example, external trade with China is usually done in USD.

(d) Where the embedded derivative is an inflation-related index (e.g. an index of lease payments
to a consumer price index) in a host lease contract, provided that the lease is not leveraged
and the index relates to inflation in the entity’s own economic environment. Other embedded
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derivatives for host lease contracts include contingent rentals based on related sales,
or contingent rentals based on variable interest rates.
 408 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Example 7.1
Looking back at Case Study 1.3 about the Bright Gold Corporation (BGC), you will note that BGC is
predominantly a gold-mining company and its functional currency is the Australian dollar. Examples
7.1a and 7.1b look at two different types of purchase contracts that BGC entered into.

Example 7.1a: An embedded derivative that needs to be separated for accounting purposes
BGC has entered into a contract to purchase a machine from a Japanese manufacturer in three
months’ time. The price of the machine is fixed at USD 1 000 000 and the current three-month forward
exchange rate is AUD/USD 1.0700. The spot rate at the time of purchase is AUD/USD 1.0800. Because
the contract is denominated in USD it would be considered a hybrid contract.

Hybrid instrument = (Host contract + Embedded derivative)

The hybrid instrument is the combination of the host contract and embedded derivative, which will
equate to paying USD 1 000 000 for this machine in three months’ time.

The host contract would be an AUD contract to pay AUD 934 579 (1 000 000 / 1.07) in three months’
time. This is the normal AUD contractual amount without any USD embedded derivative. It is the
amount that would have been contracted had the contract been settled in AUD. It is determined by the
forward rate at the time of entering into the contract—that is, the AUD amount would be determined
based on the exchange rate that can be achieved at settlement date, rather than the spot date.

The embedded derivative converts the AUD host contract to USD. It is a forward exchange contract
to sell USD 1 000 000 and receive AUD 934 579 in three months’ time.

Note that we are still paying USD 1 000 000 (net of the host contract and embedded derivative) for
this machine. In this example, we have separated it into its respective components as we need to
determine the separate accounting treatments.

If BGC were to hedge the foreign exchange exposure created by the embedded derivative, BGC
would sell AUD and buy USD, thus limiting its exposure to any volatility between the AUD and the
USD. Such a hedge contract is the opposite of the embedded derivative identified above. This is a
logical outcome as any hedge taken up would seek to offset the impact of the embedded derivative.

An alternative way to understand the embedded derivative is that it is the opposite of the hedge
instrument you would use to hedge the FX risk. The rates are set in the embedded derivative so that
there is no profit or loss on day one. Hence, the embedded derivative must be the opposite of the
hedge instrument for FX risk.

To determine the accounting treatment, the contract to purchase the machine (the hybrid instrument)
must be split into the embedded derivative and the host contract.

Receivable/(Payable)

Split into components AUD USD

Derivative—being the embedded derivative, 934 579 (1 000 000)

which is a forward exchange contract

Host contract—being the contract to purchase (934 579) —

the machine in AUD

Net exposure — (1 000 000)

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This split into components is required to assess the appropriate accounting treatment. We now need
to go through the following steps in order to determine whether the embedded derivative needs to
be separately valued under IAS 39.
 Study guide | 409

Step 1: Is the host contract fair valued?

The host contract is a purchase order that is not fair valued to the profit and loss.

The purchase contract is not a financial instrument and is unlikely to be valued at fair value (recall that
if the contract is at fair value, there is no need to separately value any embedded derivative within it).

Step 2: Is the embedded derivative really a derivative?

The embedded derivative is a forward exchange contract (FEC) that clearly satisfies the definition of
a derivative.

Since the purchase contract is denominated in USD, the Australian company will be required to convert
AUD into USD at the prevailing rate in three months’ time. Thus, the AUD cost of purchasing the
machine is exposed to foreign exchange risks. This purchase order effectively has a forward foreign
exchange contract embedded in it, where the company agrees to sell USD 1 000 000 in exchange for
AUD 934 579. This embedded derivative causes the company to have gains (losses) when the AUD
appreciates (depreciates), which subsequently changes the AUD cost of purchasing the machinery.
This contract satisfies the definition of a derivative since:
• the value of the FEC changes with exchange rates;
• there is no initial investment; and
• it is cash settled at a future point in time.

Step 3: Is the embedded derivative closely related to the host contract?

Finally, it must be determined whether the economic characteristics and risks of the FEC are ‘closely
related’ to the purchase contract.

To determine whether the embedded derivative is closely related, it is necessary to create a checklist to
summarise factors listed as a special exception in the standard relating to foreign currency derivatives
(see item c in the preceeding section, ‘Special exceptions provided by the standard’).

Factors to consider N/Y? Comments

The first two questions must be negative:

(i) Is the contract leveraged? No

Pass
(ii) Does it contain an option? No

And then at least one of the following must be answered in the affirmative:

(i) Is USD the functional currency of a substantial party to No

the contract?

(ii) Are the goods routinely denominated in USD around No

Fail
the world?

(iii) Is USD commonly used to purchase goods in the No

economic environment?

As a result of the failure above, the foreign currency embedded derivative is NOT closely related in
this example and hence must be separated for accounting purposes. Note that this is an example only
and assumes that USD is neither the routine denomination nor commonly used for such purchases
of machinery.

The existence of an embedded derivative that is not closely related has significant accounting
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implications. The embedded derivative must be separated in this example. The embedded derivative
at inception will have a fair value of zero and subsequently will be fair valued at each reporting date
until final payment, and the changes in the fair value of the embedded derivative will be taken to
the profit and loss. The machine on receipt will be recorded at AUD 934 579 with a corresponding
liability recorded.

This accounting treatment is in contrast to the situation in which the embedded derivative had been
‘closely related’ in which case the embedded derivative would not be fair valued. Instead the purchase
would be recorded at the spot exchange rate at the time of receipt of the machine.
 410 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Example 7.1b: An embedded derivative that does not need to be separated for accounting
purposes
BGC has recently entered into a contract to purchase USD 1 000 000 of aluminium from an aluminium
manufacturer in the US in five months’ time. Aluminium prices are based on the trading conducted on
the London Metal Exchange (which is denominated in USD). The five-month forward exchange rate is
AUD/USD 1.0300 and the spot rate is AUD/USD 1.0500. The host contract is the contract to purchase
aluminium. The embedded derivative is the forward exchange contract for AUD/USD, because the
contract is denominated in a different currency from the AUD, the contract is based on the value of
the USD and will be settled on a future date. The company could have negotiated to purchase the
aluminium at the fixed AUD price of AUD 970 874 (USD 1 000 000 / 1.0300), but has elected to expose
itself to AUD/USD exchange rate fluctuations. The embedded derivative is thus a forward exchange
contract to sell USD 1 000 000 and receive AUD 970 874 in five months’ time.

To determine the accounting treatment for this example, the contract to purchase the aluminium
(the hybrid instrument) must be split into the embedded derivative and the host contract.

Receivable/(Payable)

Split into components AUD USD

Derivative—being the embedded derivative 970 874 (1 000 000)

which is a forward exchange contract

Host contract—being the contract to purchase (970 874) —

the aluminium in AUD

Net exposure — (1 000 000)

This split into components is required to assess the appropriate accounting treatment. We now need
to go through the following steps in order to determine whether the embedded derivative needs to
be separately valued under IAS 39.

Step 1: Is the host contract fair valued?

Similarly to Example 7.1a, the host contract is a purchase order that is not fair valued to the profit
and loss.

Step 2: Is the embedded derivative really a derivative?

Similarly to Example 7.1a, the embedded derivative is an FEC that clearly satisfies the definition of
a derivative.

Step 3: Is the embedded derivative closely related to the host contract?

Finally, it must be determined whether the FEC is ‘closely related’ to the purchase contract.

To determine whether the embedded derivative is closely related, it is necessary to create a checklist to
summarise factors listed as a special exception in the standard relating to foreign currency derivatives
(see item c in the preceeding section, ‘Special exceptions provided by the standard’).
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 Study guide | 411

Factors to consider N/Y? Comments

The first two questions must be negative:

(i) Is the contract leveraged? No

Pass
(ii) Does it contain an option? No

And then at least one of the following must be answered in the affirmative:

(i) Is USD the functional currency of a substantial party to Yes

the contract?

(ii) Are the goods routinely denominated in USD around Yes

Pass
the world?

(iii) Is USD commonly used to purchase goods in the Yes

economic environment?

The first test is satisfied as the supplier’s functional currency is USD.

The second test is also satisfied as aluminium prices are routinely traded in USD. The term ‘routinely
denominated’ means that the product or service must be traded predominantly in that currency in
both international and domestic sales in all geographic markets. Aluminium prices are predominantly
traded in USD, therefore this satisfies the condition.

The last condition on the checklist is satisfied as the USD is the most common currency used to make
purchases from the US. As the analysis above shows, the foreign currency embedded derivative is closely
related in this example and must not be separated from the host contract for accounting purposes.

Other examples of purchase contracts with embedded derivatives that cannot be separated for
accounting purposes include contracts for the purchase of gold, silver, and crude oil, to name a few
globally traded commodities. Such commodities are always quoted and sold in USD and satisfy the
second test in the checklist in the ‘Factors to consider’ table.

Accounting for embedded derivatives

Embedded derivatives are essentially accounted for as derivatives, subject to valuation issues
noted below. Any embedded derivative that must be separated can be used in a hedge
relationship as a hedging instrument if it qualifies for hedge accounting under IAS 39.

If an embedded derivative is separated (because it is not closely related to the host contract),
the host contract shall be recognised in accordance with IAS 39 as if it is a financial instrument,
or in accordance with other appropriate standards if it is not a financial instrument.

In Example 7.1a, the forward exchange contract was separated from the purchase order and fair
valued to the profit and loss.

If an entity is required to separate an embedded derivative from its host contract but is unable to
measure the embedded derivative separately (either at acquisition or at a subsequent financial
reporting date), it shall treat the entire combined contract as a financial asset or financial liability
that is held for trading and record the combined instrument at fair value through the profit and
loss statement. Such an instrument will not qualify for hedge accounting.
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These details are summarised in Figure 7.3.

For example, a 20-year electricity supply contract may have an option to increase the price based
on an aluminium index. If the embedded derivative cannot be measured, the entire contract
must be fair valued.
 412 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Figure 7.3: Embedded derivatives

Embedded derivative
Fair value
may be designated
Yes the embedded +
as a hedging
derivative
instrument
Can the separated
embedded derivative
be measured?
Hybrid cannot
Fair value
No be designated
the entire +
as a hedging
hybrid instrument
instrument

Valuing an embedded derivative at inception

There are specific rules on the basis of valuing embedded derivatives at inception. These depend
on whether the embedded derivative is a non-option contract or an option derivative.

Non-option derivative
An embedded non-option derivative (i.e. an embedded forward or swap) is separated from its
host contract on the basis of its stated or implied substantive terms, so as to result in it having a
fair value of zero at initial recognition.

Option derivative
An embedded option-based derivative (i.e. an embedded put, call, cap, floor or swaption) is
separated from its host contract on the basis of the stated terms of the option feature. The initial
carrying amount of the host instrument is the residual amount after separating the embedded
derivative.

Example 7.2
The financial accountant at your furniture manufacturing company has just received a memorandum
from the sales department stating that it has executed a contract to sell a new range of furniture in
USD to a New Zealand-domiciled entity. The furniture was delivered on 31 March 2014. The financial
accountant believes that the USD component is an embedded derivative that does not meet the special
exceptions provided by the standard and so must be separated from the host contract. Accordingly,
she sets up the derivative instrument using the following information:

Defining the terms of the embedded derivative

Background information Answer Embedded derivative terms

Execution of contract 1/3/2014 Dealt date at 1/3/2014

Currency of sales contract USD Buy USD/sell AUD

Amount in sales contract 1 500 000 USD 1 500 000

Receipt date in sales contract 1/7/2014 Value date at 1/7/2014

AUD/USD forward rate from dealt date to 0.9250 Forward rate is 0.9250
receipt date
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As a derivative, the embedded derivative is subsequently remeasured at fair value. The embedded
derivative is a forward foreign exchange contract to buy USD 1 500 000 at the AUD/USD forward
rate of 0.9250 for value date 1/7/2014. The host contract is accounted for as an AUD denominated
executory contract.
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The company has a 31 March year end. See details below.

Rates at 31 March 2014

Forward rate to 1 July 2014 0.9500

Spot rate at 31 March 2014 Not required

Three-month discount rate 0.74783%

Days from 31 March to 1 July 92

1. Recording the sale

 he sale occurred on 1 March 2014 as this was that day when the contract terms were
T
satisfied. Hence, the sale is recorded on 1 March 2014.

Dr Accounts receivable AUD 1 621 621.62

Cr Sale AUD 1 621 621.62

The sales amount has been determined by the forward exchange rate at inception
(USD 1 500 000 / 0.9250).

2. Record the embedded derivative at fair value

To determine the fair value of the embedded derivative:

Step 1: Compute the notional gain or loss

AUD notional at inception AUD 1 621 621.62
AUD notional at 31 March
(USD 1 500 000 / 0.95) AUD 1 578 947.37
AUD notional loss on USD exposure AUD 42 674.25

This calculates the notional loss that is expected to be settled at 1 July based on forward
rates as at 31 March. This loss is a result of the AUD/USD forward rates (for a 1 July
settlement) rising from 0.9250 as at 1 March and 0.9500 as at 31 March.

Step 2: Compute the discounted amount

Discount the notional loss estimated to be settled in three months by the three-month
discount interest rate:

AUD 42 674.25 / (1 + 0.0074783) = AUD 42 357.49

Hence, the fair value is AUD 42 357.49

The accounting entry to record the loss on the embedded derivative at 31 March 2014 is:

Dr Loss on embedded derivative (profit and loss) AUD 42 357.49

Cr Embedded derivative (statement of financial position) AUD 42 357.49
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The debit is an expense (loss) in the statement of profit or loss and other comprehensive
income and the credit is a liability in the statement of financial position.

Embedded derivatives are also discussed under ‘Classification of financial liabilities’ in Module 5
of the CPA Program subject ‘Financial Reporting’.
 414 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Part B: Hedge accounting

Introduction
Hedge accounting is governed by IAS 39 Financial Instruments: Recognition and Measurement.

IAS 39 clarifies what is a hedge for accounting purposes. Failure to comply with the hedge
accounting rules will mean that any change in the fair value of derivatives must be taken straight
to the profit and loss statement. This has the potential to introduce significant volatility into the
results of affected organisations. Organisations in banking, commodities, electricity and import/
export/wholesaling will be most vulnerable because these industries tend to be significant users
of derivatives. Given that most medium-to-large companies in Australia use derivatives, this will
affect the majority of accountants.

The rules must be complied with prospectively such that if an organisation fails to document the
hedge relationship at inception, it will not achieve hedge accounting.

What is hedging?
A ‘hedge’ is put in place to cover adverse price movements. In order for an accounting hedge to
be put in place, the details and the nature of the hedge must be specified.

Specifically, to qualify as a hedge under IAS 39, the following conditions must be satisfied:
(a) At the inception of the hedge there is a formal designation and documentation of the hedging
relationship and the entity’s risk management objective and strategy for undertaking the
hedge. That documentation shall include identification of the hedging instrument, the hedged
item or transaction, the nature of the risk being hedged and how the entity will assess the
hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s
fair value or cash flows attributable to the hedged risk.
(b) The hedge is expected to be highly effective (have a ratio between 80 per cent and
125 per cent) in achieving offsetting changes in fair value or cash flows attributable to the
hedged risk, consistently with the originally documented risk management strategy for that
particular hedging relationship.
(c) For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly
probable and must present an exposure to variations in cash flows that could ultimately affect
profit or loss.
(d) The effectiveness of the hedge can be reliably measured, i.e. the fair value or cash flows of the
hedged item attributable to the hedged risk and the fair value of the hedging instrument can
be reliably measured.
(e) The hedge is assessed on an on-going basis and determined to have been highly effective
throughout the financial reporting periods for which the hedge was designated (IAS 39.88).

All of these requirements are summarised in Figure 7.4 and will be discussed in more detail below.

The importance of these factors cannot be overemphasised. Under IAS 39, all derivatives must be
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recorded on the balance sheet at fair value. If a derivative does not qualify for hedge accounting
status, the gains or losses on the derivative are taken straight to the profit and loss statement.
This can naturally cause serious volatility in the profit and loss statement.
 Study guide | 415

The underlying principle of IAS 39 is that if organisations do qualify for hedge accounting,
they should more or less achieve the same or a similar profit and loss result to that achieved
under historical cost-accounting concepts. In other words, the hedge gain or loss can be offset in
the statement of profit or loss and comprehensive income with the item being hedged.

Hedging is also discussed under ‘Impairment of financial assets and hedge accounting’ in Module 5
of the CPA Program professional level subject ‘Financial Reporting’.

Figure 7.4: Hedge accounting process

Execute Document Assess Accounting
effectiveness outcome
Execute derivative
per board/
company policy

Document hedge
for compliance
with IAS 39
requirements

Documentation to include:
• objective Assess effectiveness Fail No hedge
• strategy at inception and accounting for
• risk being hedged record results the period
• inclusion/exclusion of time value
• description of:
– hedged item Pass Fail
– hedge instrument
• various other matters
Assess effectiveness
Pass Hedge accounting
retrospectively at the
for the period
end of each period

Importance of accounting rules in relation to hedging

Being a commodity-based economy, Australia is a prolific user of derivatives. In the absence of
an accounting standard, different companies could record the same transaction in four different
ways, meaning the auditor or accountant would have no real guidance on the appropriate
method. IAS 39 clarifies the situation.

For example, a gold-mining company that thinks gold prices will be flat or falling may wish
to sell a call option at a high strike price—for example, if current prices are AUD 550 per
ounce, the mining company may be happy to sell a call option at AUD 600 at a premium of
AUD 25 per ounce. By selling the option, the gold company has added AUD 25 per ounce to
an anticipated gold price of AUD 550. However, if the gold price exceeds AUD 600 per ounce,
the company will be committed to sell gold at AUD 600. Effectively, the company has given up
the upward potential profits of higher gold prices.

So, how to account for the premium? The following approaches are possible:
• Amortise the premium over the life of the contract.
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• Take the premium to account on day of execution.

• Record the option to fair value and record gains and losses to the profit and loss.
• Defer the premium and include it in the sale at the date that it is exercised.

Under IAS 39, sold options are recorded at fair value, and gains and losses recorded to profit
and loss.
 416 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

The important benefits of IAS 39 include the potential to:

• increase the level of transparency, given that companies must clearly document the risks
being hedged and the basis for determining that the hedges are highly effective; and
• create a consistent basis for measuring derivatives—all derivatives must be measured at
fair value.

However, IAS 39 does contain a lot of rules. This has arisen out of the necessity of defining
questions such as ‘What is a qualifying hedge relationship?’ In every hedge relationship, there
must be:
• a hedge instrument;
• a hedged item;
• details of the risk being hedged; and
• formal documentation.

In addition, IAS 39 prescribes effectiveness tests that require the hedge relationship to be highly
effective, which the standard defines as offsetting fair values or offsetting cash flows between the
hedge item and hedged instruments within a range of 80 per cent to 125 per cent. For example,
if the hedge items’ fair value changes by AUD 100, to be highly effective, the hedge instrument
should change in value by AUD 80 to AUD 125.

This part provides an overview of the various rules applied under IAS 39 with simple examples of
the application of the rules. We then look at the three types of hedges under IAS 39:
• cash flow hedges;
• fair value hedges; and
• hedges of net investments.

What qualifies as a hedge instrument?

Typically, the hedge instrument will be a derivative. Accordingly, there are many rules as to how
an organisation can use a derivative in the hedge relationship. The standard also permits the use
of financial assets and financial liabilities in a hedge relationship, but these can only be used to
hedge foreign exchange risk.

Use of a derivative in a hedge relationship

As mentioned, an organisation can use a derivative as the hedging instrument but it must be
used in its entirety. In other words, an organisation cannot dissect or divide a derivative into
its component parts and use one component in a hedge relationship and another component
outside of the hedge relationship. There are two exceptions to this rule, namely:
• an organisation can exclude the ‘time value’ from the derivative (see ‘Is time value in or out
of the relationship?’ later in this module); and
• derivatives can be split on a proportionate basis.

A combination of derivatives can be a hedge instrument

The standard permits organisations to combine derivatives to create a ‘hedge instrument’.
For example an Australian company has sales of 1 million barrels of crude oil to be sold at
spot next month. The highly probable forecast transaction has price risk (USD price of oil) and
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exchange risk (USD). To hedge the barrels back to AUD it could combine an oil commodity
contract to fix the USD price of oil and a forward exchange contract to fix the USD price back to
AUD. The hedge instrument would be the combination of both contracts.

To illustrate a hedge relationship, consider Example 7.3, the case of an Australian software
company selling software to the US in US dollars.
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Example 7.3
If an Australian company is to sell USD 65 000 of software to a US customer in six months’ time, it will
not receive the current forward exchange rate of AUD/USD 0.65, but will receive the spot rate at the
date of receipt if it does not enter into a hedge instrument.

The effect of uncertainty over the exchange rate in six months’ time is illustrated in the table below.

Unhedged transaction

Actual exchange
rate (USD value
of AUD 1) 0.50 0.55 0.60 0.65 0.70 0.75 0.80 0.85

Underlying
transaction
(AUD equivalent
of USD 65 000) 130 000 118 182 108 333 100 000 92 857 86 667 81 250 76 471

The company is thus exposed to foreign exchange risk where its AUD proceeds will diminish if the
Australian dollar strengthens in six months’ time. To protect against this risk, the company could
use a forward exchange contract to lock in the rate to hedge the sale (i.e. using a forward rate of
AUD/USD 0.65 and locking in the receipt of AUD 100 000). The forward exchange contract will effectively
create gains above AUD/USD 0.65 and create losses below AUD/USD 0.65 for the company. The gains
or loss from the forward exchange contract will offset the loss or gains from exchanging the actual
USD 65 000 at the future spot rate such that the net proceeds to the Australian company are fixed.
In reality, the bank will receive the USD proceeds and provide the customer with a fixed amount of
AUD proceeds. The outcome of entering into this hedge is shown in the table below.

Transaction hedged with forward exchange contract

Actual exchange
rate (USD value
of AUD 1) 0.50 0.55 0.60 0.65 0.70 0.75 0.80 0.85

Underlying
transaction 130 000 118 182 108 333 100 000 92 857 86 667 81 250 76 471

Forward
exchange
contract
(gain/loss) –30 000 –18 182 –8 333 0 7 143 13 333 18 750 23 529

Forward
exchange
contract plus
(hedged
amount of)
underlying
transaction 100 000 100 000 100 000 100 000 100 000 100 000 100 000 100 000

Rather than locking in the exchange rate, the company may wish to obtain the benefit if the AUD
weakens but be protected in case the AUD strengthens above AUD/USD 0.65. In this case, the company
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would purchase a USD put (= AUD call) option at AUD/USD 0.65. This will cost the company the value
of the option, or premium, which is assumed to be AUD 3000). This means that if the exchange rate
is below AUD/USD 0.65 the company will be making more than would otherwise be the case if the
company used a straightforward exchange contract to hedge the transaction. The following table
shows cash flows at settlement.
 418 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Transaction hedged with USD put (= AUD call) option

Actual exchange
rate (USD value
of AUD 1) 0.50 0.55 0.60 0.65 0.70 0.75 0.80 0.85

Underlying
transaction 130 000 118 182 108 333 100 000 92 857 86 667 81 250 76 471

Purchase price
or gain on
exercise of put –3 000 –3 000 –3 000 –3 000 4 143 10 333 15 750 20 529

Total proceeds 127 000 115 182 105 333 97 000 97 000 97 000 97 000 97 000

Hedging with non-derivative financial assets and liabilities

A non-derivative financial instrument may only be designated as a hedging instrument when
hedging foreign currency risks. An entity can use foreign currency borrowings, deposits and
other non-derivative financial instruments as hedged instruments. A common example of such
a hedging relationship is a foreign currency denominated financial liability used to hedge
the net investment in a foreign operation for the foreign exchange risk associated with the
foreign operation.

➤➤Question 7.2
The CFO of your company has requested a review of the fair value amounts being carried on
the statement of financial position for all derivatives. The CFO contends that the accounting for
derivatives depends on whether the derivative is in a hedge relationship or otherwise. Explain
whether the CFO’s call for a review is justified.

Example 7.4
Your company specialises in global web-based conference technology and is considering establishing
a subsidiary in India. The CFO is concerned that there may be a mismatch introduced into the group
financial statements because:
1. the net assets of the Indian subsidiary (with an INR functional currency) will be translated to
AUD, with translation gains and losses reflected through the foreign currency reserve (a separate
component of equity); while
2. the INR borrowing taken out by the Australian parent (with AUD as the functional currency) to
fund and economically offset the INR investment in the subsidiary will have foreign currency gains
and losses recorded in AUD through profit or loss.

The CFO’s solution is to use the INR borrowing as a hedging instrument in a net investment hedge.
The effective component of, and gains and losses on, the INR borrowing is recognised in the foreign
currency reserve (as per IAS 39) and not profit or loss (as per IAS 21). This means that offsetting gains
and losses related to foreign currency borrowings and net investment will offset in the foreign currency
reserve in the consolidated accounts.

Sold options in collars

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IAS 39.77 states that two or more instruments can be designated as a hedging instrument only if:
• none of them is a written (sold) option; or
• the combined instrument is not a net written option.

This restriction prevents designating sold options as a hedging instrument.

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Sold options (written options), when used in a collar arrangement, are permissible hedge
instruments. This occurs where the sold option is offset by a purchased option in a single collar
instrument from inception. When derivatives are used in combination with a sold (written)
option, it is important to determine that the option combination is not a net written option.
IAS 39 IG F.1.3 states:
The following factors taken together suggest that an interest rate collar or other derivative
instrument that includes a written option is not a net written option.
(a) No net premium is received either at inception or over the life of the combination of options.
The distinguishing feature of a written option is the receipt of a premium to compensate the
writer for the risk incurred.
(b) Except for the strike prices, the critical terms and conditions of the written option component
and the purchased option component are the same (including underlying variable or variables,
currency denomination and maturity date). Also, the notional amount of the written option
component is not greater than the notional amount of the purchased option component.

Derivatives can be split proportionately but not on a period basis

Sometimes a single derivative may be in two different hedge relationships, or may be part within
and part outside a single hedge relationship. The standard states that in the context of hedge
accounting, an organisation can split a derivative proportionately.

For example, an organisation has a forward exchange contract for USD 65 000. The organisation
can designate USD 35 000 in a hedge relationship and USD 30 000 outside of the hedge
relationship.

However, an organisation cannot split a derivative on a time basis. For example, if an organisation
has a 10-year, receive-fixed-pay-floating interest rate swap hedging the organisation’s five‑year,
fixed-rate debt, it cannot designate the first five years of the swap as being in a hedge
relationship with the debt and the next five years as being in a no hedge relationship.

Years 0 1 2 3 4 5 6 7 8 9 10
Debt
SWAP

Is time value in or out of the hedge relationship?

As mentioned above, the fair value of a derivative must be used in the hedge relationship in
its entirety; the only exception is for time value in options and forward exchange contracts.
For options, the time value is the difference between the fair value and the intrinsic value of
the option. For forward exchange contracts, the time value is the forward points or interest
differential in the forward contract. As these value components of the derivative can be reliably
identified, they can be separated from the fair value of the derivative.

This permits the hedge relationship to exclude the fair value changes in the hedge relating to
time value changes.

For example, if a foreign exchange option is hedging an accounts receivable balance in USD,
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an organisation would exclude the time value from the option in the hedge relationship to ensure
the fair value changes in the hedging instrument (intrinsic value) match the value changes in the
accounts receivable balance. Example 7.5 provides an example of the matters to consider in
hedging with options.
 420 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Hedging with options—Treatment of time value

Unlike the US GAAP equivalent accounting standard FAS 133 (specifically, DIG1 no. G20), IAS 39
does not permit the time value of options to be deferred to equity reserves even when a perfect
cash flow hedge relationship exists. Hence, the time value of options will be excluded from
the hedge relationship and, accordingly, will be included in the profit and loss when the time
value component of fair value changes. This may cause significant profit and loss volatility when
options are a significant component of an organisation’s hedge strategy.

Example 7.5
Your company exports in USD and is considering the use of option contracts instead of forward
foreign exchange contracts as the hedging instrument to hedge its highly probable sales. The treasury
accountant recalls references to time value and options in a presentation that she went to some time
ago. However, as forward foreign exchange contracts and not option contracts were used she has
not explored in detail the implications for financial reporting. Accordingly, as a means of developing
her own understanding as a mechanism to explain the potential profit or loss impact to the financial
controller, she prepared dot points on the key aspects of hedge accounting with options.

Since the company is selling USD, it is considering purchasing a USD put (= AUD call) option with a
notional value of USD 1 million, a strike of AUD/USD 1.0600, with a cost or premium of USD 50 000.
When the AUD/USD goes above the strike rate of 1.0600, the hedge will be effective (gain).

The significant factors that came to her attention in the hedge accounting for the option were as follows:
• When the spot rate was below 1.0600, all of the change in fair value from inception date of the
hedge to the reporting date would be recognised in profit or loss.
• When the spot rate was above 1.0600, only the difference in the strike rate to the spot rate would
be recognised in the cash flow reserve.
• The premium of $50 000 is recognised in profit or loss over the entire life of the option as the fair
value of the time value changes.
• The sale of USD is effectively recognised at the strike rate (USD 1 000 000 at 1.0600 or AUD 943 396)
when the option is exercised.

➤➤Question 7.3
(a) Are there any exceptions to the rule that derivatives must be used in the hedge relationship
in their entirety?
(b) Can sold options ever be used in a hedge relationship under IAS 39?
(c) If a company has a five-year interest rate swap, can the company split it so that the first three
years are in a hedge relationship while the last two years are speculative?
(d) Can a company split a forward exchange contract so that 50 per cent is in a hedge relationship
and 50 per cent is speculative?
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1
DIG is the Derivative Implementation Group, which is the interpretative body of FAS 133.
 Study guide | 421

The hedged item

The hedged item can be:
• a recognised asset or liability;
• a firm commitment;
• a highly probable forecast transaction; or
• a net investment in a foreign operation.

The hedged item in the hedging relationship must be clearly defined in the hedge documentation.
In addition, the hedged item must be identifiable at all times. Hence, a company cannot
identify the hedged item as 30 per cent of the sales in June 2015, when the company is hedging
USD 3 million of expected sales of USD 10 million for the month. This is because the company
cannot determine when the hedged item has actually occurred. Hence, the company would
normally define the hedge as the first USD 3 million sales in June 2015.

The hedged item cannot be a net amount. For example, if a company has USD 100 in sales and
USD 70 in purchases in the same period, the standard requires that the designated hedged item
be USD 30 of sales. Note: the requirement of the standard is that you cannot hedge the net
amount of purchases and sales but you can specifically hedge USD 30 of sales.

As suggested above, a company can hedge a group of items, but IAS 39.83 states the following:
Similar assets or similar liabilities shall be aggregated and hedged as a group only if the individual
assets or individual liabilities in the group share the risk exposure that is designated as being
hedged. Furthermore, the change in fair value attributable to the hedged risk for each individual
item in the group shall be expected to be approximately proportional to the overall change in fair
value attributable to the hedged risk of the group of items.

This means that a net amount of USD purchases and sales occurring in the same month cannot
be the hedged item, because purchases and sales do not share the same risk exposure. Hence,
when hedging items as a group, it is important to give consideration to whether:
• individual items share the same risk exposure; and
• every item in the group has fair value changes that approximate the fair value change of the
entire group for the risk being hedged.

It is important to note that a derivative can never hedge another derivative, as a derivative is
not a permissible hedged item. Nevertheless, the gains and losses of both derivatives will be
recorded in the profit and loss statement and hence, if they have the opposite terms, the profit
impact should be minimal.

Recognised asset or liability

As the term suggests, recognised assets and liabilities could be any assets or liabilities on
the balance sheet—be they financial or non-financial. Recognised assets and liabilities on the
balance sheet will normally be in a fair value hedge relationship as the organisation is hedging
the value changes on those assets or liabilities.
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 422 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

A firm commitment
Firm commitment is defined as a binding agreement for the exchange of a specified quantity of
resources at a specified price on a specified future date or dates.

For example, if a company signs a legally binding sales agreement for 100 tonnes of coal to
be shipped in June 2016 for USD 1000 per tonne, the company will have a firm commitment.
The company might hedge the receipt of the USD 100 000 in June 2016 for foreign exchange risk
via a forward exchange contract. Assuming all the hedge documentation and the effectiveness
criteria are satisfied, this hedge relationship could qualify as a fair value hedge. The standard
requires the revaluation of the firm commitment in a fair value hedge on the balance sheet.
Hence, in the case of a gain, the gain on the firm commitment is recorded as an asset with the
credit simultaneously recorded to the profit and loss. The gain on the firm commitment will be
offset by the loss on the forward exchange contract, which will also be recorded in the profit
and loss.

IAS 39.87 also permits a firm commitment to be hedged as a cash flow hedge when the risk
being hedged is the foreign exchange risk. (Cash flow hedges are discussed below.)

A highly probable forecast transaction

The term highly probable is a matter of judgment based on the circumstances. Nevertheless,
IAS 39 IG F.3.7 provides the following valuable guidance.
The term ‘highly probable’ indicates a much greater likelihood of happening than the term ‘more
likely than not’. An assessment of the likelihood that a forecasted transaction will take place is
not based solely on management’s intent because intentions are not verifiable. A transaction’s
probability should be supported by observable facts and the attendant circumstances.
In assessing the likelihood that a transaction will occur, an entity should consider the following
circumstances:
(a) the frequency of similar past transactions;
(b) the financial and operational ability of the entity to carry out the transaction;
(c) substantial commitments of resources to a particular activity (for example, a manufacturing
facility that can be used in the short run only to process a particular type of commodity);
(d) the extent of loss or disruption of operations that could result if the transaction does not occur;
(e) the likelihood that transactions with substantially different characteristics might be used to
achieve the same business purpose (for example, an entity that intends to raise cash may
have several ways of doing so, ranging from a short-term bank loan to an offering of ordinary
shares); and
(f) the entity’s business plan.
The length of time until a forecasted transaction is projected to occur is also a factor in determining
probability. Other factors being equal, the more distant a forecasted transaction is, the less likely
it is that the transaction would be regarded as highly probable and the stronger the evidence that
would be needed to support an assertion that it is highly probable.
For example, a transaction forecast to occur in five years may be less likely to occur than a
transaction forecast to occur in one year. However, forecast interest payments for the next 20 years
on variable rate debt would typically be highly probable if supported by an existing contractual
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obligation.
 Study guide | 423

In addition, other factors being equal, the greater the physical quantity or future value of a
forecasted transaction in proportion to the entity’s transactions of the same nature, the less likely
it is that the transaction would be regarded as highly probable and the stronger the evidence that
would be required to support an assertion that it is highly probable. For example, less evidence
generally would be needed to support forecast sales of 100,000 units in the next month than
950,000 units in that month [even] when recent sales have averaged 950,000 units per month for
the past three months.
A history of having designated hedges of forecasted transactions and then determining that the
forecast transactions are no longer expected to occur would call into question both an entity’s
ability to accurately predict forecasted transactions and the propriety of using hedge accounting in
the future for similar forecast transactions.

Specific or period-based specification

A significant decision for an entity when hedging a highly probable forecast transaction is the
basis on which the hedged item is identified.

Period-based
An entity that has a high volume of relatively lower value foreign currency receivables arising from
a number of sources or customers may be more inclined to take on a period-based approach
to hedging. This would mean the entity designates an amount of foreign currency receivables
occurring in a particular time period, such as EUR 1 000 000 in March 2016. Should the highly
probable forecast sales fall below EUR 1 000 000 at the time the entity is performing its
hedge effectiveness tests, this will adversely affect the hedge and may result in it no longer
being effective.

Specific
An entity that has low volume but relatively higher value foreign currency payables arising from
major capital purchases may be more inclined to adopt a specifically referenced-based approach
to hedging. This would mean the entity designates the specific capital purchase as the hedged
item and to the extent the timing of the capital purchase does not occur as expected, this will
be reflected in hedge effectiveness and measurement of ineffectiveness as opposed to an
assessment that the hedged item is no longer highly probable.

Hedging instruments and hedged items are also discussed under ‘Impairment of financial assets and
hedge accounting’ in Module 5 of the CPA Program subject ‘Financial Reporting’.

➤➤Question 7.4
A company has plans to start up a gold mine and seeks advice as to whether it can hedge its
forecast sales. Can these forecasts be considered a hedge item in a hedge relationship?

A net investment in a foreign operation

When a company invests in a foreign entity with a functional currency different to its own
currency, the parent company is subject to foreign currency translation risk as a result of
investing in the subsidiary. This risk is a translation exposure to currency risk and can be the
hedged item in a hedging relationship. A ‘net investment in a foreign operation’ is the amount
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of the reporting entity’s interest in the net assets of that operation.

 424 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

The hedged risks

It is important to define exactly what risk is being hedged in the hedge relationship. There is
more flexibility in defining the risk in respect of financial assets and liabilities than non-financial
assets and liabilities.

Financial assets and liabilities

In respect of financial assets and liabilities, the hedge risk can be a portion of the risk of the
change in cash flow or fair value provided it is identifiable and separately measurable. Hence,
a financial asset or liability could be hedged for:
• overall fair value risk;
• a benchmark interest rate or risk-free interest rate2;
• credit risk; or
• foreign exchange risk.

Incidentally, an organisation cannot hedge a held-to-maturity investment for interest rate risk
or prepayment risk because there is an intention by management to hold such investments to
maturity with a fixed interest rate.

Non-financial items
For inventory and sales and purchases of non-financial items (including commodities, goods and
services, etc.), IAS 39 has restricted the risk that can be hedged, due to the difficulty of identifying
such risks in non-financial items. Hence, a hedge of non-financial items is limited to:
• foreign exchange risk; or
• overall price/cash flow risk.

This has been interpreted to mean that you can hedge:

• foreign exchange risk only;
• all risk other than foreign exchange risk; or
• all risks including foreign exchange risk.

For example, if a company with AUD functional currency sells 1000 barrels of oil for USD 60
per barrel, it can hedge separately:
1. the foreign exchange risk, estimated to be USD 60 000, via a forward exchange rate.
However, if the company only enters into a forward exchange contract to fix the AUD/USD
exchange rate (e.g. 0.9000), effectively it will have only hedged its foreign exchange exposure
and not the exposure to all other risks;
2. the price risk of 1000 barrels of oil via a futures contract, which will effectively fix the sales
price of USD 60. If the company only enters into a futures contract to fix the oil price in USD
(e.g. USD 60 / barrel), it will have effectively hedged all risk other than foreign exchange.
This occurs as the company has only hedged the USD oil price component of the purchase,
however it will still be exposed to foreign exchange movements; or
3. a combination hedge using both the forward exchange contract and the oil futures contract
to fix the total proceeds in AUD. As a result, the company will have hedged both the oil price
and the foreign exchange risk.

In the event that the company hedges foreign exchange risk separately as per item (1) above,
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the determination of the value of the ‘highly probable’ sales should exclude proceeds from the
oil futures contract (which is noted in item (2)). This follows because a derivative cannot hedge
another derivative, so if the oil price drops to USD 30 per barrel, the foreign exchange risk will
reduce to USD 30 000.

2
This refers to the impact of interest rates on the fair value of the hedged item.
 Study guide | 425

Subsequently, a forward exchange contract for USD 60 000 would be 50 per cent overhedged.
On the other hand, if the company chooses to hedge the price risk of oil using a futures contract,
as per item (2) above, the derivative (future contract) will qualify as a hedge of risks other than
foreign exchange because, unlike the forward exchange contract, it is not dependent on another
derivative to determine the price risk. Finally, the company can designate the foreign exchange
contract and the oil futures as a combination hedge where the hedged item is the proceeds from
the sale. In this case, the test of effectiveness is based on the net change in value of both the
derivatives against that of the entire hedged item being: 1000 barrels of oil × Spot price of oil in
USDs × Spot exchange rate of AUD/USD.

Summary of hedge accounting treatment

Figure 7.5: Hedge accounting
Hedge instrument Type of hedge Hedged item Accounting treatment

Gains and losses on

the hedge instruments
are deferred in equity
to the extent they are
Derivative • Variable rate financial asset or liability
effective and then
Cash flow • Highly probable forecast transaction
transferred to profit
or • Firm commitment for FX and loss to match
the underlying
financial hedged item.
asset Net investment Net investment
Gains and losses on
or the hedge instruments
are recorded to profit
liability • Fixed-rate financial assets or liability or loss. Likewise, gains
Fair value • Firm commitment and losses on the
(for FX risk only) • Non-financial asset or liability hedged item (for the
risk being hedged)
are also recorded
to profit and loss.

Cash flow hedge

A cash flow hedge is a hedge arrangement whereby the hedge effectively fixes an otherwise
variable cash flow that will affect the statement of profit or loss and other comprehensive income.
In hedge-effectiveness language, a cash flow hedge is a hedge arrangement whereby the
change in cash flows of the hedging instrument offsets the change in cash flow of the underlying
hedged item.

Cash flow hedges are hedges of forecast transactions. An example of a forecast transaction may
be interest payments on variable rate debt. This is illustrated in Example 7.6.

Example 7.6
A company may borrow funds from a bank for two years at a variable rate of the bank bill swap rate
(BBSW) plus 50 basis points (50bp). Under this borrowing arrangement, the company is subject to
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variable interest rates dependent on the BBSW rate. Hence, the interest expense has the potential to
vary greatly. At times in Australia, BBSW has varied from 2.7 per cent to 18 per cent and, accordingly,
the finance director could be quite concerned over the risk that the company faces given the interest
rate environment. To avoid this interest rate risk, the company could renegotiate the terms of the
funding so that it borrows at a fixed rate. Alternatively, the company could enter into a swap with a
different bank to receive floating BBSW and pay fixed interest. By entering into the swap, the company
has eliminated the cash flow variability via the hedge arrangement to produce a fixed cash flow and
interest expense.
 426 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Example 7.7: Part A—effectiveness

Remaining with the interest rate hedge example (Example 7.6), the details are as follows:
• Company X borrows AUD 1 000 000.
• The interest rate is BBSW plus 50bp reset quarterly.
• The term is two years.
• The swap has a fair value of zero at inception.
• At inception, the BBSW rate across all periods is a 7 per cent flat rate.

To hedge the interest rate risk, Company X enters into a swap with the following details:
• Notional principal is AUD 1 000 000.
• Receives BBSW quarterly and pays fixed 7 per cent quarterly for a term of two years.

Interest rates and fair values over the future periods are as follows.

(i) Loan interest payments

Principal AUD 1 000 000

Period 1 2 3 4 5 6 7 8

BBSW 5.00% 6.00% 5.00% 6.00% 7.00% 7.00% 8.00% 8.00%

Margin 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50%

Interest rate 5.50% 6.50% 5.50% 6.50% 7.50% 7.50% 8.50% 8.50%

Interest paid A –13 750 –16 250 –13 750 –16 250 –18 750 –18 750 –21 250 –21 250

A = (Principal × Interest rate × 1/4)

(ii) Swap payments and receipts

Period 1 2 3 4 5 6 7 8

Receive
(BBSW) 12 500 15 000 12 500 15 000 17 500 17 500 20 000 20 000

Pay fixed –17 500 –17 500 –17 500 –17 500 –17 500 –17 500 –17 500 –17 500

Net B –5 000 –2 500 –5 000 –2 500 0 0 2 500 2 500

B = (Receive – Pay)

(iii) Combination of the swap and the loan interest

If the swap is effective, when the company combines the cash flows of the swap and the loan,
it should result in fixed interest payments.

Period 1 2 3 4 5 6 7 8

Combine A+B –18 750 –18 750 –18 750 –18 750 –18 750 –18 750 –18 750 –18 750

When the company combines the variable interest payments on the loan with the net swap amount,
it equates to an effective fixed interest rate of 7.50 per cent—being the 7 per cent fixed coupon on
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the swap plus the 50bp over BBSW paid on the loan. The fact that the cash flows have been converted
from a variable cash flow to a fixed cash flow is a demonstration that the cash flow hedge is effective.
 Study guide | 427

Cash flow hedge

25 000
20 000
15 000
Cash payments

10 000 Interest payments (A)

5 000 Net payments (A+B)
— Swap payments (B)
–5 000 1 2 3 4 5 6 7

–10 000
–15 000
Time

(iv) Hedge assessment of effectiveness

To qualify for hedge accounting, IAS 39 requires that an organisation demonstrate prospectively and
retrospectively that the hedge is effective. This can be demonstrated using the ‘dollar offset’ method.

Period 1 2 3 4 5 6 7 8

Fair value*

Hypothetical A –33 314 –14 243 –24 089 –9 636 0 0 2 451 0

Swap B –33 314 –14 243 –24 089 –9 636 0 0 2 451 0

Dollar offset A/B 100% 100% 100% 100% 100% 100% 100% 100%

* Fair values used in this material are for illustrative purposes only—see Appendix 7.1 for calculations.

As expected, in this case when the company uses the dollar offset method the ratio is 100 per cent.
This confirms our previous expectation that the hedge is highly effective.

Accounting for a cash flow hedge

As with all derivatives, the derivative cash flow hedge must be recorded at fair value on the
balance sheet. A derivative with a positive fair value will be shown as an asset, and a derivative
with a negative fair value will be recorded as a liability. Under cash flow hedge accounting,
the derivative gain or loss is deferred to equity to the extent that the hedge is effective,
provided that the hedge satisfies the documentation requirements and the requirement that
the hedge be highly effective. Any ineffective component, as a result of being over-hedged,
will be taken to the profit and loss statement immediately.
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Example 7.7: Part B—journal entries

Continuing with Example 7.7, in period 1 the company would record the following entries.

Journal entry (period 1) Dr Cr

Cash 1 000 000
Loan 1 000 000
To record the loan at inception

Interest expense 13 750

Cash 13 750
To record the interest payment for the period

Interest expense 5 000

Cash 5 000
To record the swap payment

Equity 33 314*
Derivative (Liability) 33 314 *

To record the fair value of the derivative at the end of the period. As the derivative is 100 per cent
effective, the entire change in fair value goes to the hedge reserve.

* Fair values used in this material are for illustrative purposes only—see Appendix 7.1 for calculations.

In period 2, there are two approaches that the company could adopt. In most cases both approaches
will produce the same result. Option 1 is a short-cut approach, whereas option 2 is the theoretically
correct approach.

Option 1: Auto reversing approach

Journal entry (period 2) Dr Cr
Interest expense 16 250
Cash 16 250
To record the cash payment of the interest

Interest expense 2 500

Cash 2 500
To record the cash payment of the swap

Derivative (Liability) 33 314*

Equity 33 314 *
To reverse the derivative valuation from the previous period

Equity 14 243*
Derivative (Liability) 14 243 *
To insert the correct derivative value at the end of the period

* Fair values used in this material are for illustrative purposes only—see Appendix 7.1 for calculations.
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 Study guide | 429

Option 2: Transfer via cash flow reserve approach

Journal entry (period 2) Dr Cr
Interest expense 16 250
Cash 16 250
To record the cash payment of the interest

Derivative (Liability) 2 500

Cash 2 500
To reduce the derivative by the amount of cash paid

Derivative (Liability) 16 571*

Equity 16 571*
To adjust the derivative value to equate to the fair value
of the derivative at the end of period 2.
(33 314 – 2 500 – 14 243 = 16 571)

Interest expense 2 500

Equity 2 500
To adjust the interest expense to equate the appropriate fixed amount.
See Example 7.7 Part A for interest calculated.

* Fair values used in this material are for illustrative purposes only—see Appendix 7.1 for calculations.

Option 1 will produce the correct balance sheet and profit and loss in most instances of cash flow
hedging. This may not be the case in all instances, especially if there are periods when the hedge has
not been highly effective. Option 2 is the theoretically correct way to record transactions. Irrespective
of the method selected, the balance sheet and the profit and loss statement should, under either
method, produce the same result.

Option 2 reflects the fact that gains and losses are deferred in equity, then released to the profit and
loss to reflect the underlying hedge relationship. Specifically, IAS 39.100 states: ‘For cash flow hedges
… amounts that had been recognised in other comprehensive income shall be reclassified from equity
to profit or loss … in the same period or periods during which the hedged forecast cash flows affect
the profit or loss’.

Accounting for cash flow hedges of a non-financial asset or liability

Frequently, the cash flow hedge may hedge a highly probable forecast purchase of inventory
or plant and equipment. When this is the case, the entity has a choice as to the accounting
treatment of the gains or loss from hedging the purchase.

The accounting choices are as follows. The entity can either:

(a) reclassify the associated gains and losses from equity into profit or loss in the same period
or periods during which the acquired asset affects the profit or loss statement (such as in the
periods that depreciation expense or cost of sale is recognised); or
(b) remove the associated gains and losses deferred in equity and include them in the initial cost
or other carrying amount of the asset or liability (in which case they would automatically affect
profit or loss when the item is depreciated or sold) (IAS 39.98).

Tracking of the deferred gains and losses on cash flow hedges in equity (method (a) above) is
important and can be difficult. The standard makes this process easier for non-financial assets
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because it permits the gains and losses on the hedge to be transferred into the cost base of
the underlying inventory or plant and equipment being hedged, on recognition of the asset
(method (b) above).
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Termination of the cash flow hedge

The following circumstances may result in the termination of the cash flow hedge.

Table 7.3: Termination of the cash flow hedge

Circumstance Accounting treatment

1. The hedge instrument The cumulative gain or loss on the hedging instrument that has been
expires, is sold, recognised in other comprehensive income (OCI) from the period when
terminated or the hedge was effective shall remain separately in equity until the forecast
exercised transaction occurs.

2. Hedge no longer The cumulative gain or loss on the hedging instrument that has been
meets the criteria for recognised in OCI from the period when the hedge was effective shall remain
hedge accounting separately in equity until the forecast transaction occurs.

3. The forecast is no Any related cumulative gain or loss on the hedging instrument that has been
longer expected recognised in OCI from the period when the hedge was effective shall be
to occur reclassified from equity to profit or loss as a reclassification adjustment.

4. The entity revokes the The cumulative gain or loss on the hedging instrument that has been
hedge designation recognised in OCI from the period when the hedge was effective shall remain
separately in equity until the forecast transaction occurs or is no longer
expected to occur.

Cash flow hedge impairment test

Where a deferred loss in equity exists and an organisation expects that all or a portion of the loss
will not be recovered in future periods, it must reclassify from equity the amount not expected
to be recovered into profit and loss. For example, if an organisation hedges sales with a forward
exchange contract and incurs losses that are deferred to the hedge reserve, it must expect to
make a profit on the sale after accounting for the loss in the hedge reserve.

Fair value hedge

A fair value hedge is a hedge that seeks to offset the exposure to fair value changes that will
affect the profit and loss. It will be considered effective if the fair value changes of the derivative
offset the value changes of the underlying hedged item. The simplest way to remember the fair
value hedge relationship is to consider the opposite of a cash flow hedge (i.e. hedging a fixed-
rate loan). Each time interest rates move, the value of the loan changes as a result of interest
rate movements. Thus, to eliminate the fair value exposure on a fixed-rate loan, the company
would enter into a swap that converts it from a fixed-rate loan to a variable-rate loan. As a result,
the value changes on the loan due to interest rate movements will be offset by value changes
on the swap.

Per IAS 39, the following items can be hedged in a fair value hedge relationship:
• a recognised asset;
• a recognised liability; and
• a firm commitment.
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It is important to specify in a fair value hedge the exact cash flows that are being hedged
as well as the risks that are being hedged. Failure to specify accurately will typically lead to
ineffectiveness in the hedge relationship and may ultimately cause it to no longer be regarded
as a highly effective hedge.
 Study guide | 431

Example 7.8
An example of a fair value hedge is a hedge of fixed-rate debt. For example, a company has borrowed
AUD 1 million from a bank for two years at a fixed rate of 7 per cent. Under this borrowing arrangement,
the company is subject to fair value exposure to interest rate changes. For example, if interest rates
fall, the fair value of the loan will increase. By entering into an interest rate swap (to pay floating and
receive fixed), the company has eliminated the fair value risk of the value of the loan rising or falling
as a result of interest rate changes. The swap involves a receipt of fixed 6.5 per cent coupon quarterly
and payment of BBSW quarterly based on a AUD 1 million notional amount. Effectively, the swap has
converted the loan from a fixed-rate loan to a variable-rate loan (BBSW + 0.5%).

It is important to define the risk being hedged and the cash flows being hedged. First, the risk being
hedged is the risk of the benchmark interest rate which, in this case, is the fixed 6.5 per cent coupon.
This is the interbank swap rate for two years. It is important to note that other factors can also affect the
value of the company’s debt. However, in this case, these factors are not being hedged. For example,
if the company starts as a AAA-rated company then later becomes a BBB-rated company, this will
also affect the value of the company’s debt. However, this is not the attributable risk being hedged
in this case. Accordingly, fair value changes relating to credit risk can be ignored. The second step
is to define the cash flows being hedged. In this case, we will only hedge the fixed coupon on the
underlying loan to the extent of 6.5 per cent of the fixed coupon (i.e. we will not hedge the 7 per cent
coupon as to do so would itself create ineffectiveness).

(i) Loan interest payments

Principal 1 000 000

Period 1 2 3 4 5 6 7 8

Fixed rate 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00%

Portion 6.50% 6.50% 6.50% 6.50% 6.50% 6.50% 6.50% 6.50%

hedged

BBSW 5.00% 6.00% 5.00% 6.00% 7.00% 7.00% 8.00% 8.00%

(benchmark)

Actual A* –17 500 –17 –17 –17 –17 –17 –17 –17 500
interest 500 500 500 500 500 500
paid

Hedged C** –16 250 –16 –16 –16 –16 –16 –16 –16 250
amount 250 250 250 250 250 250
of interest
(benchmark
cash flows)

* AUD 1 000 000 × (7% × ¼).

** AUD 1 000 000 × (6.5% × ¼).

The first step is to identify the specific cash flows that will be hedged. These are noted as the benchmark
cash flows identified in C above.
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(ii) Swap payments and receipts

Period 1 2 3 4 5 6 7 8

Swap

Receive
(6.5%) 16 250 16 250 16 250 16 250 16 250 16 250 16 250 16 250

Pay
(BBSW) –12 500 –15 000 –12 500 –15 000 –17 500 –17 500 –20 000 –20 000

Net B 3 750 1 250 3 750 1 250 –1 250 –1 250 –3 750 –3 750

(iii) Combination of the swap and the loan interest

Period 1 2 3 4 5 6 7 8

Combine A+B –13 750 –16 250 –13 750 –16 250 –18 750 –18 750 –21 250 –21 250

The combination of the swap and the fixed-rate loan has resulted in coupon payments that equate
to a variable-rate loan of BBSW plus 50bp—the 50bp being the difference between the fixed rate at
inception of the loan and the two-year benchmark rate under the swap.

(iv) Hedge assessment of effectiveness

As with cash flow hedges, to qualify for hedge accounting, IAS 39 requires that the company demonstrate
prospectively and retrospectively that the hedge is highly effective. In this example, we can demonstrate
that the hedge is effective at inception as the actual swap equates to the hypothetical perfect swap
that would be used to hedge the risk of benchmark interest rate movements. This is referred to as the
matched terms approach—see more details in ‘Hedge effectiveness’ later in this module.

For the retrospective test, we will use the dollar offset method—again, see more details in ‘Hedge
effectiveness’ later. For an example of the testing, see the ratio analysis in the table below.

Ratio offset test of effectiveness

Period 1 2 3 4 5 6 7 8

Fair value –1 024 985 –1 007 121 –1 018 067 –1 004 818 –996 378 –997 564 –996 324 0
debt*

Fair value 24 985 7 121 18 067 4 818 –3 622 –2 436 –3 676 0

swap*

Change in value**

Debt† E –24 985 17 864 –10 945 13 249 8 440 –1 187 1 241 –3 676

Swap F 24 985 –17 864 10 945 –13 249 –8 440 1 187 –1 241 3 676

Ratio E/F 100% 100% 100% 100% 100% 100% 100% 100%
offset

* Fair values used in this material are for illustrative purposes only—see Appendix 7.1 for calculations.
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** Calculated as the change in fair value = current period fair value less the fair value in the previous
period fair value.
†
In period 1, debt change in fair value = debt face value ($1 000 000) less fair value of debt in period 1
(1 024 985); in period 2, debt change in fair value = fair value of debt in period 1 (1 024 985) less fair
value of debt in period 2 (1 007 121).
 Study guide | 433

As can be demonstrated by this ratio offset, it is possible to see that over the life of the hedge, it has
been perfectly effective (i.e. the fair value changes of the derivative over time perfectly offset the fair
value changes of the underlying loan for interest rate changes). If the changes in fair values of the
debt and swap were significantly different, there would be ineffectiveness in the hedge relationship.
This is further explained later in the module (see the headings ‘Hedge effectiveness’ and ‘Dollar offset
method’).

Accounting for a fair value hedge

The accounting for fair value hedges is straightforward once one has defined the hedge
relationship and determined the fair value changes of both the hedging instrument and the
hedged item. The derivative is fair valued and the associated value changes are recorded in the
profit and loss. Then the hedge item is fair valued for the attributable risk for which it is being
hedged and recorded in the profit and loss statement. It is important to remember that when the
underlying hedged item is fair valued for a specific risk, this is not the same as a normal fair value
calculation. In Example 7.8, the loan is fair valued for interest rate changes. This is not the same
as a fair valuation of the loan (i.e. this is not the same amount that the company would receive if
the company sold the loan).

The accounting entries in the first period are as follows:

Journal entry (period 1) Dr Cr

Cash 1 000 000
Loan 1 000 000
To record the initial loan amount

Interest expense 17 500

Cash 17 500
To record the interest expense for the period

Cash 3 750
Interest expense 3 750
To record the cash received under the
swap arrangement

Derivative (asset) 24 985

Derivative (P&L) 24 985
To record the derivative at fair value

Loan fair value change (P&L) 24 985

Loan 24 985
To revalue the loan for interest rate changes

In this example, the last two entries indicate that the revaluation of the derivative perfectly
mirrors the revaluation of the loan. This is expected in the present example as the hedge
instrument is a mirror image of the loan and, accordingly, any fair value change due to interest
rate movements on the loan will be replicated by the derivative.
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The accounting entries in the second period are as follows.

Journal entry (period 2) Dr Cr

Interest expense 17 500
Cash 17 500
To record the interest expense for the period

Cash 1 250
Interest expense 1 250
To record the cash received under the
swap arrangement

Derivative (P&L) 17 864

Derivative (asset) 17 864
To record the derivative at fair value

Loan 17 864
Loan fair value change (P&L) 17 864
To revalue the loan for interest rate changes

Termination of the fair value hedge

An organisation must terminate its fair value hedge accounting if the:
• hedge derivative expires, is sold, is terminated or is exercised;
• hedge no longer qualifies for hedge accounting; or
• organisation revokes the designation.

If one of the above events occurs, the previous fair value adjustments to the loan, while in the
hedge relationship, will become part of the amortised cost base of the hedged item (the loan).
The interest calculation on the hedged item will subsequently adjust to reflect the amortisation
of the deferred gain or loss on an effective yield basis over the remaining life of the loan.
For example, if the hedge in the previous example is terminated at the end of year 2, the fair
value adjustment on the loan (AUD 7121) will be amortised to the profit and loss statement over
the remaining life of the loan.

➤➤Question 7.5
(a) If a company hedges a forecast transaction, will this be a cash flow hedge or a fair value
hedge?
(b) Assume a derivative is hedging a sale in 2015 in a highly effective hedge relationship. What
should happen to the gain on termination of the derivative one year prior to settlement if
the forecast hedged transaction is still expected to occur?
(c) If a forecast sale is no longer expected to occur, must the derivative gain hedging the sale
be recognised immediately in the profit and loss?
(d) If a company hedges fixed-rate debt with an interest rate swap to convert the debt to
floating-rate debt, is this a fair value or cash flow hedge?
(e) If a company hedges a highly probable purchase of inventory, is there an alternative to
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recording the gains/losses on the derivative in equity until the inventory is recorded in the
profit and loss?
(f) If a company seeks to hedge variable-rate debt with an interest rate swap, is this a fair value
hedge or a cash flow hedge?
 Study guide | 435

Net investments in a foreign operation

Why is there a need for net investment hedges?
On consolidating the results of a foreign operation with a different functional currency to that of
the parent entity, IAS 21.39 requires:
• ‘assets and liabilities’ to be ‘translated at the closing rate’;
• income and expenses to be translated at the transaction rate (an average rate is often used);
• all resulting gains and losses to be ‘recognised in other comprehensive income’.

IAS 21.15 also requires that where an entity has a monetary item that is receivable from or
payable to a foreign operation, for which settlement is neither planned nor likely to occur in the
foreseeable future, the exchange difference on the monetary item is recognised as a separate
component of equity as it is, in substance, part of the net investment.

In the absence of hedge accounting, the foreign exchange gains and losses on re-translating
the net assets of the foreign operation on consolidation would be taken directly to equity
(in accordance with IAS 21), while those of any loan taken out to finance the investment would
go to profit or loss. This creates a mismatch that is eliminated if hedge accounting is adopted.

A hedge of a net investment in a foreign operation is a hedge of the foreign currency exposure
to changes in the reporting entity’s share in the net assets of that foreign operation. Hedges
for net investments are in the nature of fair value hedges that are accounted for like a cash flow
hedge. The hedge can be assessed on a before- or after-tax basis. This needs to be specified in
the hedge documentation (per IAS 39 IG F.4.1).

Frequently, the question is asked as to whether a company can hedge the profit forecast from a
subsidiary for foreign exchange gains and losses. The answer is that parent companies cannot
hedge forecast profits. Profits are a net outcome of different transactions and hence do not
qualify as a hedge item under IAS 39.

Example 7.9
Details of the net investment are as follows.

Net foreign investment hedge

Investment in subsidiary USD 60 000
AUD equivalent investment at inception 100 000
Historical AUD/USD rate 0.60
Year-end AUD/USD rate 0.50

The subsidiary has maintained the cash injection from the parent in cash. As a result of the weakening
AUD over the year, when the company converts the USD cash balance back to AUD at the end of
the year, the company has made a gain of AUD 20 000 (i.e. using USD 60 000 / 0.500 – AUD 100 000).
Unfortunately, in this case the parent company has hedged the net investment with a forward exchange
contract and the loss on the forward exchange contract over the year was AUD 25 000. Of this loss,
AUD 20 000 was due to a change in the intrinsic value of the hedge contract and AUD 5000 was due
to time value changes in the forward exchange contract.

The parent company has prepared appropriate hedge documentation and also assessed the hedge
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as highly effective on a matched terms basis. The effectiveness tests excluded time value from the
calculation of effectiveness. The company could have elected to hedge the forecast sale of the
subsidiary, in which case it could have included the time value in the hedge relationship.

A further assessment of the effectiveness of the hedge was done using a cumulative dollar ratio offset
method (see ‘Dollar offset method’ later) and, in each period, the hedge was found to be highly
effective. At the end of the year, the hedge was highly effective, as the ratio was 100 per cent
(AUD 20 000 / AUD 20 000).
 436 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Accounting for hedges of net investments

To show the accounting entries, a mock consolidation of a parent company with an American
subsidiary is presented below.

Elimination entry
Parent company Sub company Sub company Group
AUD USD AUD Dr Cr AUD
Assets
Cash 60 000 120 000 120 000
Investment in
sub 100 000 100 000 0
100 000 60 000 120 000 120 000

Liability
Derivative –25 000 –25 000
Net assets 75 000 60 000 120 000 95 000

Equity
Capital 100 000 60 000 100 000 100 000 100 000
Translation
reserve 20 000 20 000 0
Profit and loss 20 000 –5 000
75 000 60 000 120 000 95 000

The elimination entry reflects the fact that, from a group perspective, the investment account and
the equity balance must be eliminated. This is an intercompany transaction and, on consolidation,
all inter-group transactions must be eliminated. The capital account is always recorded at the
historical exchange rate such that it can be eliminated on consolidation.

In the parent entity’s accounts, the AUD 25 000 losses on the forward exchange contract went
straight to the profit and loss. On consolidation, the hedge was highly effective, and hence
AUD 20 000 was transferred to the hedge reserve. This excluded the AUD 5000 losses relating
to the time value of the forward exchange contract that remain in the profit and loss statement.
The AUD 20 000 translation gain made by the subsidiary is also reflected in the translation reserve
account on consolidation.

The impact of the net investment hedge can be seen in the group accounts.

➤➤Question 7.6
(a) When a company hedges a net investment with a derivative, assuming all the criteria of
IAS 39 are satisfied, where in the accounts would the company record the hedge gains and
losses?
(b) If a company hedges a net investment in a foreign operation, must the company apply the
same formal documentation under IAS 39?
(c) If a company were to hedge a net investment in a foreign operation with a forward exchange
contract, would the company exclude the time value from the forward exchange contract?
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 Study guide | 437

Hedge effectiveness
The following are requirements of IAS 39.
• The hedge is expected to be highly effective in offsetting changes in fair value or cash flows
attributable to the hedged risk, consistent with the originally documented risk management
strategy for that particular hedging relationship.
• The effectiveness of the hedge can be measured reliably (i.e. the fair value or cash flows of
the hedged item that are attributable to the hedged risk and the fair value of the hedging
instrument can be reliably measured).
• The hedge is assessed on a continuing basis and determined to have been highly effective
throughout the financial reporting periods for which the hedge was designated.

Hence, the company must expect the hedge to be ‘highly effective’, it must be able to reliably
measure the effectiveness of the hedge, and it must reassess the hedge regularly. Failure in any
of these categories means that the hedge will not qualify for hedge accounting. IAS 39.AG105
describes this assessment as a two-stage process. Specifically, it states that:
A hedge is regarded as highly effective only if both of the following conditions are met.
(a) At the inception of the hedge and in subsequent periods, the hedge is expected to be highly
effective in achieving offsetting changes in fair value or cash flows attributable to the hedged
risk during the period for which the hedge is designated …
(b) The actual results of the hedge are within a range of 80–125 per cent. For example, if actual
results are such that the loss on the hedging instrument is CU 1203 and the gain on the cash
instruments CU 100, offset can be measured by 120/100, which is 120 per cent, or by 100/120,
which is 83 per cent. In this example, assuming the hedge meets the condition in (a), the entity
would conclude that the hedge has been highly effective.

Hence, there is a requirement to assess the effectiveness of the hedge prospectively and
retrospectively.

The standard requires effectiveness assessments at inception of the hedge (prospective test) and
as a minimum at the end of each reporting period (prospective and retrospective). A company
can elect to do more frequent assessments.

The standard does not prescribe a specific method for assessing hedge effectiveness
(IAS 39 AG107), but it requires an entity to specify at inception of the hedge relationship the
method it will apply to assess hedge effectiveness, and to apply that method consistently for
the duration of the hedge relationship. When the terms of the hedged item for the hedged risk
match the significant terms of the hedging instrument, an entity may form a conclusion that it
expects the hedge to be highly effective. This approach is known as matched terms.

Other mathematical techniques relying on simple ratios or more complex regression analysis are
also commonly applied and are respectively termed:
• dollar offset—cumulative and period; and
• regression.

Most other hedge effectiveness tests are a derivation of the above and to this extent are not
introduced in this module.
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Essentially, three tests are undertaken to establish hedge effectiveness: a test at inception of
the hedge; a test at completion of the hedge effectiveness period known as the retrospective
test; and a test at the commencement of the next period known as the prospective test.
The retrospective test must be a function of past results and, to this extent, matched terms
cannot be used for this type of test.

3
CU is short for ‘currency unit’.
 438 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

The role of the hypothetical derivative

The hypothetical derivative is the derivative that will perfectly hedge the specific risk of the
hedged item. It will have a fair value of zero at inception and its maturity will typically be the
same as the underlying hedged item, being the term of the designated hedge.

The hypothetical derivative perfectly hedges the hedged item for the designated risk. For example,
assume the underlying debt (hedged item) was to pay a floating rate (risk = floating rate) every six
months for the next three years on $1 million. In this scenario, the hypothetical derivative would be
structured with a matching $1 million notional to receive the six-month floating rate and pay a fixed
rate every six months for the next three years, as this will ensure that the cash flows are fixed for the
designated risk.

The hypothetical derivative has two roles. Both are relevant only to cash flow hedges and net
investment hedges. The hypothetical derivative can, firstly, be used as a measure to assess
hedge effectiveness and, secondly, to record any ineffectiveness in the hedge relationship that is
recognised through profit or loss.

Hedge effectiveness of the hypothetical derivative

IAS 39.AG105(a) states that a hedge can be regarded as highly effective ‘in various ways,
including a comparison of past changes in the fair value or cash flows of the hedged item that are
attributable to the hedged risk with past changes in the fair value or cash flows of the hedging
instrument …’.

In order to compute the effectiveness of a cash flow hedge, it is necessary to measure the change
in the present value of the cash flows on the hedged item. F.5.5 of the IAS 39 Implementation
Guidance establishes two methods of accomplishing this measurement.
• Method A—Compute change in fair value of the underlying hedged item
This involves comparing the hedged item (assuming it is fixed at inception) with a revised
estimate of the hedged item if fixed at the end of the period.
• Method B—Compute change in fair value of cash flows or hypothetical derivative
This is referred to as the ‘hypothetical derivative’ method because the comparison is between
the hedged fixed cash flows on the hedged item and the current variable cash flows, which is
the same as creating a hypothetical derivative for the designated risk of the hedged item.

The hypothetical derivative method is commonly used as it is the simpler method to use
in practice.

See Appendix 7.1 for examples of these two methods.

The hypothetical derivative is therefore not a hedge effectiveness method in itself. For example,
in assessing effectiveness, the ratio dollar offset method in a cash flow hedge compares the
change in fair value of the hedging instrument (or actual derivative) to the change in fair value
of the hypothetical derivative. Similarly, a regression approach to hedge effectiveness in a cash
flow hedge relationship would most likely use the actual derivative and a hypothetical derivative
under a range of scenarios.
MODULE 7
 Study guide | 439

Example 7.10
Your organisation is issuing six-month BBSW floating-rate bonds with a five-year maturity and the
treasurer indicated that they will be swapped to fixed for the full term. The BBSW six-month reset dates
are 30 June and 31 December each year. In the past, the treasury function has dealt only three-month
BBSW interest rate swaps, resetting quarterly at 31 March, 30 June, 30 September and 31 December.
The financial controller is seeking to understand both how the effectiveness of the hedge will be
assessed and how the concept of the hypothetical derivative applies in this situation. The financial
controller has therefore asked you to construct the hypothetical derivative, including an explanation
of the steps you went through to determine the details. The financial controller is aware that if a
three-month rate swap is dealt today at 5.9 per cent for five years, it is compared to the hypothetical
derivative. Accordingly, you prepare the following.

Question Answer Terms of the hypothetical

derivative

What is the hedge Today 1/1/20X5 Designation date = 1/1/20X5

designation date?

What is the hedged item and Six-monthly interest payments The receive floating leg of the
hedged risk? occurring on 30 June and 31 hypothetical swap has six-
December for changes in six month interest coupons, with
month BBSW the rate being reset on 30 June
and 31 December

Interest reference is six-month

BBSW

What is the hedge period? From today to 31/12/20X9 From designation date to
maturity date = 31/12/20X9

What is the fixed interest rate 6% The pay fixed leg of the
for the hypothetical terms hypothetical swap is fixed at a
defined above that sets the The 6% is solved by using BBSW rate of 6%
fair value to zero? swap rates as at 1/1/20X5

Measurement of ineffectiveness
In a fair value hedge, the change in fair value of the derivative is recognised in profit or loss while
at the same time the change in fair value of the hedged item is also recognised in profit or loss.
Since both changes in values are recognised through profit or loss, the extent to which they do
not offset each other in ineffectiveness is recognised through profit or loss.

In a cash flow hedge, ineffectiveness can be measured as the difference between the change
in fair value of the actual derivative and the change in fair value of the hypothetical derivative.
It is important to note, however, that when the change in fair value of the hypothetical derivative
is greater than the change in fair value of the actual derivative, there is no ineffectiveness.
This requirement stems from IAS 39.96:
More specifically, a cash flow hedge is accounted for as follows:
(a) the separate component of equity associated with the hedged item is adjusted to the lesser of
the following (in absolute amounts):
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(i) the cumulative gain or loss on the hedging instrument from inception of the hedge; and
(ii) the cumulative change in fair value (present value) of the expected future cash flows on the
hedged item from inception of the hedge;
(b) any remaining gain or loss on the hedging instrument or designated component of it (i.e. not
an effective hedge) is recognised in profit or loss …
 440 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

In practical terms, this works as shown in Table 7.4.

Table 7.4: Measurement of ineffectiveness

Change in fair value of Change in fair value of Equity (cash flow Profit or loss
actual derivative hypothetical derivative reserve) Dr/(Cr) (ineffectiveness) Dr/(Cr)

110 100 (100) (10)

100 110 (100) 0

(110) (100) 100 10

(100) (110) 100 (0)

For example, assume at inception that the fair value of the derivative was nil, and at the end of
year 1 the fair values are as follows:

Actual fair value is 100.

Hypothetical fair value is 110.

The amount that can be deferred in equity is 100. There is no ineffectiveness in the hedge
relationship. The hedge has been effective in fixing cash flows to the extent of the actual
derivative. In other words, in a cash flow hedge, there is no P&L penalty if an organisation is
under-hedged. There is a possibility of taking advantage of this rule, but IAS 39 further states that
an organisation cannot intentionally under-hedge to benefit from this rule. At IAS 39.AG107A,
it states that ‘if an entity hedges less than 100 per cent of the exposure on an item, such as
85 per cent, it shall designate the hedged item as being 85 per cent of the exposure and shall
measure ineffectiveness based on the change in that designated 85 per cent exposure’.

Consider an alternative example where the fair values are as follows:

Actual fair value is 110.

Hypothetical fair value is 100.

In this case there will be ineffectiveness recorded in the profit and loss of 10. Hence,
the accounting entry will be:

Dr Actual derivative (asset) 110

Cr Equity reserve 100
Cr Derivative profit (P&L) 10

Matched terms
Under the matched terms approach, you determine whether the hedge is highly effective via an
analysis of the critical terms of the hedge and the hedged item. This approach suggests that if
all critical terms of the hedge instrument match the perfect hypothetical hedge for the attributed
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risk, you can conclude that the actual hedge instrument will equate to the hypothetical hedge
instrument. Accordingly, the actual hedge will be highly effective provided that the terms do not
change. This approach is more suited to cash flow hedges but can be used in some instances
for fair value hedges. This approach can only be used as a prospective test, as a retrospective
effectiveness test requires measurement.
 Study guide | 441

If this method is used as a prospective effectiveness test, it is important in the documentation

to note the critical terms of the hypothetical hedge and ensure that these match to the actual
hedge instrument. This is not the preferred method of effectiveness testing because hedge
transactions do change over their life such that they may not always perfectly match.

Assessing effectiveness prospectively

The assessment can be achieved using a number of methods including the dollar offset method,
the regression method and the matched terms method. Other methods may also be appropriate
provided that they demonstrate the effectiveness of the hedge in achieving offsetting cash flows
or fair values. The dollar offset and regression methods are examined briefly below.

Dollar offset method

Under this method, the change in fair value of the derivative is compared to the change in fair
value of the hedged item for the attributed risk being hedged. This is one of the simplest forms
of measuring hedge effectiveness and, accordingly, may not be the most reliable measurement
basis. At inception, there will not be actual observations. Therefore, to prove effectiveness,
prior market data will be used.

Table 7.5 is an example of a hedge-effectiveness calculation.

Table 7.5: Hedge-effectiveness calculation

Dollar offset
Derivative: Hedged item
Change in fair value Period Cumulative
fair value change offset offset

Period A B A/B Sum A / Sum B

1 100 –96 104% 104%

2 50 –51 98% 102%
3 80 –75 107% 104%
4 24 –20 120% 105%
5 66 –55 120% 108%
6 –77 65 118% 105%
7 –44 47 94% 108%

The dollar offset may be done on a cumulative basis or a period-to-period basis. Note that the
cumulative basis will provide a more stable measure of effectiveness. A cumulative basis should
be used for cash flow hedges. All periods reflect that the hedge is ‘highly effective’.

Regression
A regression is a statistical method used to determine the relationship between two variables
and can be used to determine whether or not the hedge is highly effective. You can compute the
statistical measures using the Excel program.
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Specifically, regression looks at the changes in the value of the hedged item at X(t) with the
change in the value of the hedge instrument at Y(t). If Y is a good hedge of X, the observed
points (X,Y) should be clustered close to a straight line with a slope equal to –1.
 442 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Figure 7.6: Examples of regression lines

Y Y
R2 = 1 R2 = 0
Slope = –1 Slope = 0
× ×
×
×
× ×
×
× ×
× ×
×

X X

Using the Excel function for the same data used for the dollar offset results above yields the
following results.

Table 7.6: Regression calculations using Excel

Summary output

Regression statistics

Multiple R 0.996523296
R square 0.99305868
Adjusted R square 0.991670416
Standard error 6.012486847
Observations 7

Coefficients

Intercept 0.040119325
X variable 1 –1.074157647

The key measures to watch are the R square and the coefficient of the X variable. The R square
should be within a range of 0.804 to 1.00 and the coefficient (referred to as ‘X variable 1’) should
be between –0.8 and –1.25. These measures have been chosen as they are regression equivalents
to the dollar offset measure of the 80–125 per cent. The R square measure indicates the offset
between the X variable and the independent variable (or spread against the line of best fit),
and the coefficient indicates the ratio of the offset between the X variable and the independent
variable (or the slope of the line of best fit).

In using regression analysis, care should be taken to ensure that there is an appropriate sample
size. General practice is to use enough data points to provide a valid F-test. This is normally in
a range of 36 observations, but can be less in some situations. It is important to note that seven
observations as in the current sample would not be sufficient.

Some regression models applied also incorporate the T-statistic and F-statistic. A 95 per cent
confidence level for these statistics is applied. The T-statistic evaluates the probability that the
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slope is zero, while the F-statistic evaluates the probability that there is linear relationship.

4
Some firms require the R square factor to be above 0.96.
 Study guide | 443

Assessing hedge effectiveness retrospectively

IAS 39 requires companies to measure the ‘actual results’ of the hedges retrospectively.
This suggests that companies use the dollar offset method for testing hedges retrospectively.
Other methods such as regression analysis can also be employed. This is an area still
subject to interpretation and accordingly, you should discuss with the company’s auditor the
appropriateness of other methods. Documentation must be maintained on the results of this.

Accounting for fair value hedges, cash flow hedges and assessing hedge effectiveness are also
discussed under ‘Measurement’ in Module 5 of the CPA Program subject ‘Financial Reporting’.

➤➤Question 7.7
(a) For a hedge to be considered ‘highly effective’, what are the parameters within which the
change in fair value of the derivative and hedged item must be offset?
(b) A staff member in the accounting department is attempting to explain the concept of being
‘highly effective’. The staff member mentions that the change in value of the derivative
should be compared to the change in value of the hypothetical perfect hedge. It has been
established that in the first period the derivatives value changed by AUD 2600 and the
hypothetical changed by AUD 2350. Does this mean that this is highly effective?
(c) When a company assesses hedge effectiveness prospectively, is there a single method the
company must use to assess effectiveness?
(d) Can ineffectiveness in a hedge be deferred to match with the hedge item when it is recorded
in the profit and loss?

Hedge documentation
Hedge accounting is all about management’s intent. Accordingly, unless this is documented
at the inception of the transaction, there is a risk that management could window-dress the
accounts. IAS 39 has numerous documentary requirements and failure to comply with these
requirements at inception of the hedge will mean that the hedge will not qualify for hedge
accounting.

Hedge policy
Given the complexity of IAS 39, it is unreasonable to expect most accountants to be able to
comprehend the standard without having been specifically trained in its content and application.
Hence, as a practical measure of communicating IAS 39 throughout the company, it is important
to have a policy document that is user-friendly and covers all the requirements of the standard.

This will be used by the front, middle and back offices in their day-to-day documentation of
hedges. It will be frequently used as the basis for specifying the functional requirements in a
system implementation.

Needless to say, the policy document is important and should go through the appropriate
approval process, which might include approval by:
• senior management;
• the board’s audit and risk committee; and
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• the company’s auditor.

It is important that such a document be maintained for any changes in hedge arrangements
or hedge accounting requirements in the future and that such changes go through the same
approval process.
 444 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

A contents list for such a policy manual may look as follows:

1. Purpose of the policy.
2. Permitted hedge arrangements.
3. Basis for highly probable forecasts.
4. Embedded derivatives.
5. Documentation requirements.
6. How effectiveness is assessed.
7. How ineffectiveness is measured.

It would normally include various appendices on the following topics:

• Glossary of IAS 39 terms.
• Example of the accounting entries for the different types of hedges.
• Example of the hedge documentation.
• Valuation methodology for the various hedges.
• Resolution of interpretations made under IAS 39.

Hedge documentation
Even if the hedge relationship is considered to be eligible for hedge accounting, documentation
of the hedge relationship must be in place at inception of the hedge relationship. Until the
necessary documentation is in place, a company cannot apply hedge accounting. There can be
no retrospective designation of a hedge relationship.

Specifically, IAS 39 states that at the inception of the hedge, there must be formal designation
and documentation of:
• the hedging relationship; and
• the entity’s risk management objective and strategy for undertaking the hedge.

That documentation shall include identification of:

• the hedging instrument;
• the hedged item or transaction;
• the nature of the risk being hedged; and
• how the entity will assess the hedging instrument’s effectiveness in offsetting the exposure
to changes in the hedged item’s fair value or cash flows attributable to the hedged risk
(IAS 39.88(a)).

Figures 7.7 and 7.8 are simple examples of the type of documentation required for a cash
flow hedge.
MODULE 7
 Study guide | 445

Figure 7.7: Hedge designation worksheet

Date: 1/01/2015

Hedge ID no.: H10001

Business unit/Subsidiary: ABC Ltd

Accounting hedge type: Cash flow hedge

Hedge strategy: To hedge against the variability in cash flows from fluctuations in the
Australian benchmark interest rates.

Hedged risk: Australian interest rate risk

Hedge objective: ABC will enter into an interest rate swap (IRS) to convert its floating
rate AUD loan into a fixed rate AUD loan.

Hedging instrument: IRS (AUD interest rate swap—floating to fixed)

IRS:

Transaction reference no. I30001

Counterparty XYZ Bank Aus

Currency AUD

Fixed rate payer ABC Ltd

• Fixed rate 5.50%

Floating rate payer XYZ Bank Aus

• AUD floating rate 6-month BBSW

Start date 15/01/2015

Termination date 15/01/2020

Frequency of receipt/payment 6-monthly

Notional amount AUD 1 500 000

Hedged item: Highly probable future interest and principal payments.

Transaction reference no.: L40001

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If a forecasted transaction:

Description of transaction Interest and principal payment on AUD 1 500 000 loan.

Currency AUD

Basis for being highly probable Contractual obligation under existing financing documentation.
 446 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Figure 7.8: Hedge effectiveness—assessment

Prospective and retrospective test: Regression method

Details of regression calculation: See Hedge Policy document

Results:

Date of test: Results Workpaper

reference

Documentation can be simplified depending on the type of hedges that the company executes.
Figures 7.7 and 7.8 demonstrate the formal nature of the documentation required for each
transaction at inception.

➤➤Question 7.8
(a) What must be included in the formal documentation at the inception of a hedge to qualify
for IAS 39 hedge accounting?
(b) If a company has a qualifying hedge item and hedge instrument that is highly effective, but
forgets to prepare the documentation, is it acceptable to retrospectively prepare the formal
documentation?

Foreign currency transactions

IAS 39 permits the use of financial assets and liabilities denominated in a foreign currency to
be a hedge of a net investment in a foreign operation (as discussed earlier in ‘Net investments
in a foreign operation’). This provision essentially corrects for the mismatch in the treatment
of foreign denominated assets and liabilities when applying IAS 21. Generally, IAS 21 requires
foreign exchange gains/losses from translating a foreign operation to be taken to equity,
while those gains/losses from translating monetary liabilities would be recognised in the profit
and loss statement.

IAS 21 covers the treatment of foreign currency transactions and accordingly creates important
rules for financial assets and liabilities denominated in a foreign currency.

Introduction to IAS 21: The effects of changes in foreign exchange rates

IAS 21 explains how to include foreign currency transactions and foreign operations in the
financial report of an entity and how to translate the financial report into a presentation
currency5. The standard requires that:
(a) each entity is to determine its functional currency and measure its results and financial
position in that currency;
(b) foreign currency transactions are to be recorded, on initial recognition, in the entity’s
functional currency by applying the exchange rate at the date of the transaction. Functional
currency has a specific definition, which is explained in the next section;
(c) monetary items are to be translated at subsequent reporting dates by applying the closing
rate, with exchange differences recognised as income or expense for the period;
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(d) non-monetary items are to be translated at subsequent reporting dates by applying the
rate at the date of the transaction or revaluation, with exchange differences arising on
non‑monetary items being recognised in the same way as the related gain or loss on the
non‑monetary item;

5
Presentation currency is the currency in which you present your report; for example, an Australian
company might wish to present its report in USD to US investors.
 Study guide | 447

(e) an entity is to select a presentation currency or currencies that may or may not be its
functional currency;
(f) an entity is to translate its financial report to the presentation currency if the entity’s
presentation currency is different from its functional currency. The entity must translate assets
and liabilities at the closing rate, and income and expense items at the rate that applied at
the date of each transaction. Exchange differences are recognised as a separate component
of equity; and
(g) where an entity uses a presentation currency that is not the functional currency, the entity
must disclose the reason and justification for the choice of presentation currency.

IAS 21 essentially requires that an entity first determine its functional currency. The entity then
translates foreign currency items into its functional currency and reports the effects from this
translation either in the profit and loss statement or equity accounts. If the functional currency
is different from the currency in which the entity presents its financial reports, the entity must
translate assets and liabilities at the closing rate and income and expense items at the rate that
applied at the date of each transaction.

Generally, for the measurement of a financial asset or financial liability at fair value, cost or
amortised cost:
1. The foreign currency amount in which the item is denominated is determined in accordance
with IAS 39.
2. The foreign currency amount is translated into the functional currency using the closing
rate or a historical rate in accordance with IAS 21 (IAS 39.AG83). For example, if a monetary
financial asset (such as a debt instrument) is carried at amortised cost under IAS 39, the
amortised cost is calculated in the currency of denomination of that financial asset.
3. The foreign currency amount is recognised using the closing rate in the entity’s financial
statements (IAS 21.23).
4. Any change in the value of the asset from last financial year caused by changes in the
exchange rate is then brought into the profit and loss statement. This procedure applies
regardless of whether a monetary item is measured at cost, amortised cost or fair value in the
foreign currency (IAS 21.24).

Determining functional currency

IAS 21.8 defines functional currency as the currency of the primary economic environment in
which the entity operates. The primary economic environment is generally the one in which the
entity primarily generates and expends cash.

The functional currency is usually the currency that mainly influences sales prices for the entity’s
goods or services and is the currency of a country whose competitive forces and regulations
mainly determine the sales prices of the goods or services. It is also usually the currency in which
funds from financing (debt and equity instruments) or operating (sales receipts) activities are
generated.

When a reporting entity has a foreign operation, the foreign operation’s functional currency
may be different from the reporting entity’s. Whether the foreign entity’s functional currency is
the same as the parent’s depends on whether its activities are carried out as an extension of the
reporting entity rather than being carried out with significant autonomy.
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IAS 21.12 prescribes that if ‘the functional currency is not obvious, management uses its
judgement to determine the … currency that most faithfully represents the economic effects of
the underlying transactions, events and conditions’. Once the functional currency is determined,
the currency is not changed unless there are significant changes to the underlying circumstances.
Naturally, the results and financial position of each individual entity making up the reporting entity
(or group) must be translated into the currency in which the reporting entity presents its financial
statements. The presentation currency of the group is known as the presentation currency.
 448 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

New hedge accounting model under IFRS 9

Effective date and early adoption
As mentioned in the introduction to this module, a new hedge accounting model was released
as part of the third phase of IFRS 9.

While IFRS 9 can be early adopted, the mandatory application date is 1 January 2018. Furthermore,
the proposed changes relating to macro hedging of interest rate portfolios (which is specific
to banks) are not yet finalised. As a result, the IASB provides the following choices for any
organisation early adopting IFRS 9:
(a) adopt the IFRS 9 new hedge accounting model;
(b) adopt the IFRS 9 new hedge accounting model for all hedges except for a fair value hedge of
the interest rate exposure of a portfolio of financial assets or financial liabilities which would
continue under IAS 39; or
(c) continue applying the IAS 39 hedge accounting model.

It is unlikely that many companies will early adopt the IFRS 9 hedge accounting model given the
significant effort involved, unless there are significant advantages in doing so. In order to take
advantage of the new hedge accounting model, the entire standard must be adopted. As with
any implementation of a new standard, a careful project plan is required to ensure a smooth
transition. The plan should include measures to:
(i) determine budget and project plan;
(ii) train staff (in both finance and treasury);
(iii) identify key differences in accounting treatment across all accounts;
(iv) identify changes in hedge approaches, systems and documentation;
(v) resolve any interpretational issues, transition approach and confirm choices where
applicable;
(vi) communicate plans, timetables and results to the board and external auditors; and
(vii) obtain approval to implement as proposed.

Some of the hedge accounting steps are quite involved. For example, if treasury wishes to take
advantage of an option-based hedge strategy for the first time:
• all staff would need to be trained on the specific requirements of the new hedge accounting
model;
• the board would need to be comfortable with the new strategy;
• the treasury policy may need to be updated along with treasury reporting;
• the treasury system would need to be changed to comply with IFRS 9 (this would depend on
the vendor having an updated IFRS 9 compliant version of the software) and then tested; and
• the accounting policy/hedge documentation would require changing.

There would need to be a budget for upgrading the treasury system, a budget for training
and, potentially, a budget to engage a specialist to update the accounting policy and hedge
documentation.

The key features of the new hedge accounting model are noted below.
MODULE 7

Hedging risk components on non-financial items

The new standard permits the designation of risk components of hedged items if they are
separately identifiable and reliably measurable, irrespective of whether the item that includes the
risk component is a financial or non-financial item. Previously, risk components could only have
been segregated for financial items. The determination of being able to separately identify and
reliably measure appropriate risk components would require an evaluation of the relevant facts
and circumstances.
 Study guide | 449

Example 7.11
A company purchases aluminium cans for soft drinks (sodas). Under the purchase order, the purchase
price is variable over time and has two components: an AUD price component for the processing cost
as well as the USD price of the aluminium used in the can. Each component is approximately 50 per cent
of the value of the can but can vary significantly over time. The processing cost is indexed to AUD
labour costs and, as such, is updated every six months. The USD price of aluminium is referenced to
the London spot market and is updated monthly. The aluminium component is normally hedged with
an aluminium commodity swap whereas the processing costs cannot be hedged.

Under IAS 39, all price components had to be part of the hedge relationship with the swap, which
meant that the hedge relationship would not be highly effective, as the change in processing costs
will not move in alignment to the aluminium commodity swap.

However, IFRS 9 permits designation of just the aluminium component in the hedge relationship with
the swap, which should mean a perfect hedge effectiveness result.

Processing cost
(AUD) indexed IAS 39
to AUD labour
Aluminium
costs
can price
components
Aluminium IFRS 9
Aluminium
cost (USD) indexed
commodity
to spot aluminium
swap
price

Remove volatility with an option strategy

Hedge accounting under IAS 39 requires that fair value changes in the ‘time value’ component of
a purchased option must be recorded in the statement of profit or loss and other comprehensive
income (P&L), even when the option is in a qualifying hedge relationship. This can create significant
volatility in the P&L. The new model permits the time value component to be accounted for as a
cost of hedging, depending on whether the hedged item is transaction-based (e.g. a hedge of a
forecast transaction) or time period-based (e.g. a hedge of interest rate risk on a three-year loan).

For hedges of transaction-based items, the time value of the option contract (to the extent that
it is related to the hedged item) would initially be deferred in other comprehensive income
(OCI). Subsequently, any amount deferred in accumulated other comprehensive income (AOCI6)
would be:
1. included in the initial cost or carrying amount of a recognised non-financial asset or non-
financial liability arising from the hedged transaction; or
2. reclassified into P&L as the underlying hedged item affects the P&L.

For hedges of time period-based items, the time value of the option contract (to the extent
that it is related to the hedged item) would initially be deferred in OCI. Subsequently, any
amount deferred in AOCI would be reclassified into P& L using a systematic and rational process
(possibly a straight line amortisation approach) over the period during which the hedged item is
expected to affect the P&L.
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6
OCI is not closed off to retained earnings and so any amounts deferred to OCI are accumulated and
referred to as AOCI.
 450 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Amortisation of forward element of forward contracts

Under IAS 39, entities which elect to designate the forward contract in its entirety (the ‘forward
rate method’) for transaction-based items achieve a similar accounting result to the change for
time value of options (already discussed under ‘Remove volatility with an option strategy’).

However, for time period-related hedged items, no similar allowance is provided and entities
must either designate only the spot element (with fair value changes in the forward points
recognised in the P& L) or use the forward rate method which will result in ineffectiveness
similar to designating only the spot element.

The new model will permit the recognition of the forward element that existed in a forward
contract at inception of a hedging relationship to be accounted in the same way as the time
component of option contracts discussed earlier. Alternatively, an organisation can elect to
account for changes in the forward element in a manner consistent with IAS 39.

➤➤Question 7.9
An organisation has a two-year USD loan and is considering applying the new hedge accounting
model.
Assumed data:
• Loan amount: USD 1 000 000
• Spot at inception: 0.9400
• Forward contract entered at inception to hedge the repayment of the USD 1 000 000 for
AUD 1 111 111
Calculate the forward element (being the difference between the USD notional amount converted
at the forward rate and the spot rate) and the amount of the forward element to be allocated to
the P&L for the first year. Specify how the forward element is recognised in the P&L each year.

Basis risk in cross-currency swaps

Basis spreads are charged in cross-currency interest rate swaps (CCIRS) as a way of balancing
the supply and demand of currencies. Along with regular pay and receive interest payments,
the counterparties exchange what is known as the cross-currency basis swap spread. The basis
spread is the additional margin on top of the benchmark interest paid by the counterparty
making non-US dollar payments. This additional margin above the benchmark interest rate is
the cost of entering into the CCIRS. Typically, the basis spread in Australian dollar–US dollar
cross-currency basis swaps is positive and is therefore paid by the counterparty making the
regular Australian dollar payments, although this counterparty receives the basis spread on those
occasions when it is negative. The new model specifically allows foreign-currency basis spread in
foreign currency derivatives to be treated similarly to the forward element in a forward contract.

New hedge effectiveness requirements

Prospective effectiveness testing is still required but retrospective testing will no longer be
required—although organisations must still measure and recognise hedge ineffectiveness at
the end of each reporting period. The new hedge accounting model replaces the rigid 80 to
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125 per cent effectiveness threshold in IAS 39 with a more qualitative threshold. Specifically,
IFRS 9 employs a principles-based approach.
 Study guide | 451

The following conditions must be met for a hedge relationship to qualify as effective:
• there is an economic relationship between the hedged item and the hedge instrument;
• the effect of credit risk does not dominate the fair value changes that result from the
economic relationship; and
• the hedge ratio of the hedging relationship is the same as that resulting from the quantity of
the hedged item that the entity actually hedges and the quantity of the hedging instrument
that the entity actually uses to hedge the quantity of the hedged item.

This change significantly simplifies the initial and recurring documentation associated with hedge
accounting.

Rebalancing
The new model provides an opportunity to rebalance a hedge relationship rather than simply
disallow and force a re-designation. The new model introduces the concept of rebalancing a
hedging relationship (i.e. reducing or increasing the quantities of the hedging instrument or the
hedged item in order to maintain an appropriate hedge ratio) when the organisation’s hedge
relationship no longer satisfies the hedge ratio criterion but its risk management objective
remains the same for the hedge relationship. The organisation must adjust the hedge ratio so
that it meets the hedging criteria prospectively. This improves effectiveness and eliminates the
complexities around the revoking and re-designation of a new hedge relationship under the
current requirements.

Example 7.12
An Australian company has a simple hedge program as it only has a single highly probable sale of
USD 1 000 000 in June 20X5 which is based on a US customer’s proposed purchase. The company
early adopted IFRS 9 on 1 January 20X4. On the same day, it executed a forward exchange contract to
convert the USD 1 000 000 to AUD 900 000 and formally documented the hedge in accordance with
the new rules. At 30 June 20X4, the customer confirmed the order. However, the price had reduced,
resulting in proceeds of USD 790 000 in June 20X5 (instead of the USD 1 000 000 as first estimated).
At 30 June 20X4, the assumed loss on the forward exchange contract amounted to AUD 100 000, the
assumed loss on the hedge item was AUD 79 000.

To highlight the advantages of the new hedge model, we compare the different treatments under
IAS 39 and IFRS 9.

Under IAS 39, this hedge arrangement would have failed hedge accounting as the hedge ratio at
30 June 20X4 would have been 79 per cent (i.e. AUD 79 000 / AUD 100 000). This is outside the rigid
80 per cent to 125 per cent stipulated range, thereby failing the retrospective hedge effectiveness
test. Hence, the entire loss on the forward contract would be reported to profit or loss for the period
ended 30 June 20X4. To continue hedge accounting in the next period, the company would need to
re-designate 79 per cent of the forward exchange contract in a new hedge relationship.

As the company had early adopted IFRS 9, there is no retrospective hedge effectiveness test, so only
the ineffective portion of AUD 21 000 (i.e. AUD 100 000 – AUD 79 000) of the loss would be taken to
profit or loss. Furthermore, on 1 July 20X4, IFRS 9 would permit the hedge instrument to be rebalanced
such that for the next period only 79 per cent of the forward exchange contract would continue in
the hedge relationship.
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Derivatives may be included as part of the hedged item

Economic exposures frequently have more than one risk. For example, crude oil has commodity
price risk and foreign currency risk. Even though these two risks can be managed together,
entities often use different risk management strategies for the commodity price risk and the
foreign currency risk. The new model permits a derivative to be aggregated together with
the non-derivative hedged item. This creates a new qualifying hedged item referred to as an
‘aggregated exposure’. For example, imagine an exporter of crude oil wishes to hedge the
foreign exchange risk at a later time. Under IAS 39, the foreign exchange hedge can only hedge
the highly probable forecast sale of crude oil. However, under the new model, the company will
be able to hedge the aggregated USD exposure created by the forecast sale of oil, as well as the
hedge taken out to fix the price of the crude oil.

Expanded portfolio hedges

Under IAS 39, there are instances where hedge accounting cannot be applied to groups of
items unless all items in the group are ‘similar’ whereas, for risk management purposes, items
are often hedged on a group basis. The new standard will permit groups of individually eligible
hedged items to be hedged collectively as a group, provided the group is managed together for
risk management purposes, irrespective of whether the items are similar. For example, if a bank
wished to hedge a group of fixed interest loans, under IAS 39 all loans had to be ‘similar’ which
meant they had to change in fair value in a similar way. This effectively meant loans had to be
grouped within time buckets (e.g. all two-year loans in one group, all three-year loans in another
group). The new standard permits all such loans to be hedged in one portfolio as long as they are
managed together for risk management purposes.

Net hedges permitted

Companies often hedge net positions; for example, they may hedge a net foreign exchange
position of 20 that is made up of an asset of 100 and a liability of 80. IAS 39 does not allow net
positions to be hedged. However, the new standard will extend the use of hedge accounting to
net positions, thereby improving the alignment with risk management.

Increased eligibility of hedging instruments

The new model allows financial instruments at fair value through profit or loss to be designated
as hedging instruments. Under IAS 39, only non-derivative financial instruments hedging foreign
exchange risk qualify as hedge instruments for hedge accounting.

Extension of fair value option

The new hedge accounting model extends the use of the fair value option in two common risk
management activities to provide an alternative to formal hedge accounting while providing a
similar accounting result.

(a) Use of credit derivatives in hedging

When an organisation uses a credit derivative measured at fair value through profit and loss
to manage credit risk of all or a portion of credit exposure on a financial asset or liability,
it may designate all or a portion of the credit exposure at fair value through profit and loss—
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provided the name and seniority of the financial instrument referenced in the credit derivative
match the hedged credit exposure.

(b) Own-use contracts

In addition, the new hedge accounting model permits entities to account for ‘own-use’
contracts (contracts to buy or sell non-financial items for own use) at fair value through P&L
if it eliminates an accounting mismatch.
 Study guide | 453

For example, a wholesaler of electricity in Australia sells industrial customers fixed price electricity
contracts for two years. It then buys electricity at spot from the market and hedges the spot
price risk by entering into fixed price swap contracts with an electricity generator. Economically,
this enables the wholesaler to fix its purchase price of electricity and thus lock in a gross margin.
To achieve a smooth accounting result, the company could adopt formal cash flow hedge
accounting for the swap contracts or, as an alternative, it could apply the fair value of own-use
contracts in point (b) to simply fair value the customer contracts. This latter approach would mean
the fair value changes of the customer’s contracts would offset the fair value changes of the swap
contract in the profit and loss. The fair value of own-use contracts may be a simpler accounting
approach when the wholesaler manages the customer contracts on a portfolio approach.

Discontinuing hedge relationships

Under IAS 39 a hedging relationship is discontinued when:
1. the hedging instrument expires, is sold or terminated;
2. the hedging relationship no longer meets the qualifying criteria;
3. the organisation revokes the hedge designation; or
4. the forecast cash flow hedge is no longer expected to occur.

Under the new hedge accounting model, the same facts and circumstances will generally still
trigger a discontinuation of the hedging relationship. However, an organisation cannot voluntarily
de-designate a hedge relationship (see item 3 above).

Increased disclosures
Along with the above changes in IFRS 9, IFRS 7 disclosures have been modified to require
disclosures of information on risk exposures being hedged and for which hedge accounting is
applied. Specific disclosures will include:
• a description of the risk management strategy;
• the cash flows from hedging activities; and
• the impact hedge accounting will have on the financial statements.

➤➤Question 7.10
(a) Under the new hedge accounting requirements of IFRS 9, how would a hedge with an
effectiveness ratio of 126 per cent at the end of the period be treated?
(b) IFRS 9 introduces a new hedged item referred to as an ‘aggregated exposure’. Provide an
example of a qualifying aggregated exposure.

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 454 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Review
This module illustrated the rules associated with accounting for derivatives under IAS 39, as well
as providing the key features in the new hedge accounting model under IFRS 9.

The valuation of derivatives and compliance can be onerous. Nevertheless, the penalty for failing
to achieve hedge accounting will, in most cases, add significant volatility to an organisation’s
reported results. This may not be an issue for small, privately owned organisations, but will be
significant for large or listed entities.

Fortunately, valuation models are readily available7 for commonly used derivatives and, once
a standard process (including policy and templates) is developed for derivatives, the hedge
accounting requirements should become a formality.

Note: The module on financial instruments in the CPA Program subject ‘Financial Reporting’ covers:
• when financial instruments should be recognised and derecognised and how, once recognised,
they should be measured;
• impairment of financial assets;
• hedge accounting and financial instruments;
• presentation of the instruments once recognised; and
• appropriate information to disclose.
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7
See: http://www.fincad.com for an example of models available.
 Appendix 7.1 | 455

Appendix
Appendix

Appendix 7.1
This appendix discusses:
1. fair value calculations for the cash flow hedge using the hypothetical hedge approach;
2. fair value calculations for the cash flow hedge using the change in cash flow approach; and
3. fair value calculations for the fair value hedge.

As discussed previously the purpose of this module is to provide a high level understanding
of derivative valuations to assist with understanding the accounting entries, it is not to make
participants experts in the valuation of derivatives. For further information please see additional
reading materials referenced at the end of this module.

Accordingly in this appendix we have simplified the process. Specific simplifications include:
• ignoring credit margins and the impact of credit on derivative valuations;
• ignoring bank profit margins in derivative trades;
• simplifying day count formulas;
• assuming a perfect hedge relationship;
• assuming a flat discount rate (whereas in practice the interest curve would need to be
derived for each cash period from source information); and
• assuming cash payments occur on the last day of the quarter.
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 456 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

1. Fair value calculations for the cash flow hedge using the
hypothetical hedge approach
We start by assuming the same facts as Example 7.7. They are not repeated here, although the
loan table and the assumed facts are presented below.

Table A7.1

i Loan interest payments

Principal AUD 1 000 000

Period 1 2 3 4 5 6 7 8

BBSW 5.00% 6.00% 5.00% 6.00% 7.00% 7.00% 8.00% 8.00%

Margin 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50%

Interest rate 5.50% 6.50% 5.50% 6.50% 7.50% 7.50% 8.50% 8.50%

Interest paid A –13 750 –16 250 –13 750 –16 250 –18 750 –18 750 –21 250 –21 250

A = (Principal × Interest rate × 1/4)

ii Swap payments and receipts

Period 1 2 3 4 5 6 7 8

Receive
(BBSW) 12 500 15 000 12 500 15 000 17 500 17 500 20 000 20 000

Pay fixed
interest rate –17 500 –17 500 –17 500 –17 500 –17 500 –17 500 –17 500 –17 500

Net B –5 000 –2 500 –5 000 –2 500 0 0 2 500 2 500

B = (Receive – Pay)

iii Combination of the swap and the loan interest

If the swap is effective, when the company combines the cash flows of the swap and the loan, it should result in
fixed interest payments.

Period 1 2 3 4 5 6 7 8

Combine A+B –18 750 –18 750 –18 750 –18 750 –18 750 –18 750 –18 750 –18 750

Fair values are listed in Table A7.2.

Table A7.2
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Period 1 2 3 4 5 6 7 8

Fair values

Hypothetical A –33 314 –14 243 –24 089 –9 636 0 0 2 451 0

Swap B –33 314 –14 243 –24 089 –9 636 0 0 2 451 0

Dollar offset A/B 100% 100% 100% 100% 100% 100% 100% 100%
 Appendix 7.1 | 457

Determination of fair values for period 1

Table A7.3

End of Discount 5.00%

period 1 rate

1 2 3 4 5 6 7

Notionals Rec 12 500 12 500 12 500 12 500 12 500 12 500 1 012 500

Notionals Pay 17 500 17 500 17 500 17 500 17 500 17 500 1 017 500

PV Rec 1 000 000 12 346 12 193 12 043 11 894 11 747 11 602 928 175

PV Pay 1 033 314 17 284 17 071 16 860 16 652 16 446 16 243 932 758

Fair value of swap –33 314

Under the interest rate swap (IRS) the company receives the floating BBSW and pays fixed over
the life of the swap. The fair value of the swap will change over time based on the discounted
cash flows of the expected receipts less the expected payments. At the end of period 1, note that
there are now only seven periods remaining in the swap.

The first step in the fair value calculation of the actual swap (the hedge instrument) is to compute
the notional cash flows under the swap. The pay leg of the swap is a fixed interest rate and
accordingly is computed based on the notional amount multiplied by the fixed rate. The receive
leg of the swap is based on a variable BBSW rate which has been assumed is 5 per cent at the
end of all periods, hence the interest received on the receive leg is calculated as the notional
amount multiplied by 5 per cent. The reason we assume 5 per cent for all periods is because
we cannot forecast the variable rate for the future periods (i.e. at the end of period 1 this is
an unknown).

At the end of the swap the notional amount of the swap has been added to both legs. This is
not necessary as the notional on the pay leg cancels the notional on the receive leg; however,
it has been included to assist in the analysis of the changes in fair value of the swap. For example,
in the above case it can been seen that the change in value of the swap is driven by the loss
on the pay leg; that is, the pay leg was fixed at 7 per cent but interest rates at the end of the
first period are 5 per cent. Hence the company has locked into a higher rate than the current
market rate.

After the notional cash flows are determined, they are then discounted to a present value
equivalent. In this simplified calculation all cash flows are discounted by 5 per cent. The net
present value of the cash flows is the fair value of the IRS.
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 458 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Determination of fair values for period 2

Table A7.4

End of Discount
period 2 rate 6.00%

1 2 3 4 5 6

Notionals Rec 15 000 15 000 15 000 15 000 15 000 1 015 000

Notionals Pay 17 500 17 500 17 500 17 500 17 500 1 017 500

PV Rec 1 000 000 14 778 14 560 14 345 14 133 13 924 928 260

PV Pay 1 014 243 17 241 16 987 16 736 16 488 16 245 930 547

Fair value of swap –14 243

At the end of period 2 the same process is followed, and this is repeated until the end of the life
of the IRS. At the end of period 2, note that there are now only six periods remaining in the swap.

Hypothetical derivative
As the hypothetical derivative is the same as the actual derivative, the computation of the
hypothetical derivative will be the same as the actual derivative which was calculated above.
If the terms of the underlying debt differed from the terms of the actual derivative (i.e. reset dates,
reference rate, start or maturity date), we would change the terms of the hypothetical derivative
to match the terms of the underlying debt. This is because the purpose of the hypothetical
derivative is to simulate the change in cash flows of the underlying debt (hedged item). The fair
value of the hypothetical derivative can also differ from the actual derivative even when they have
the same terms because there are no changes for credit recognised in the hypothetical derivative.

2. Fair value calculations for the cash flow hedge using the
change in cash flow approach
Usually effectiveness of a cash flow hedge is measured using a hypothetical derivative to
determine the amount that can be deferred in the hedge reserve. This being the lesser of the
following (in absolute amounts):
(i) the cumulative gain or loss on the hedging instrument from inception of the hedge; and
(ii) the cumulative change in fair value (present value) of the expected future cash flows on the
hedged item from inception of the hedge (IAS 39.96).

The hypothetical derivative is used to determine the cumulative change in fair value (present
value) of the expected future cash flows on the hedged item because it is the simplest way
to do the calculation. However, it is important to understand the origins of the hypothetical
derivative. Accordingly, in this section the facts from Example 7.7 have been repeated in order
to compute the change in present value of the hedged item.

Note that given the simplified facts of the example, this method produces the same result as
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the actual derivative and the hypothetical derivative. It should always produce the same result
as the hypothetical derivative. But it is important to understand this approach to assist in the
understanding of how the hypothetical derivative can and does vary from the actual derivative.
 Appendix 7.1 | 459

Determination of fair values for period 1

Table A7.5

End of Discount 5.00%

period 1 rate

1 2 3 4 5 6 7

Notionals Revised 12 500 12 500 12 500 12 500 12 500 12 500 1 012 500

Notionals Original 17 500 17 500 17 500 17 500 17 500 17 500 1 017 500

PV Revised 1 000 000 12 346 12 193 12 043 11 894 11 747 11 602 928 175

PV Original 1 033 314 17 284 17 071 16 860 16 652 16 446 16 243 932 758

Fair value of swap 33 314

To determine the present value of the change in cash flows on the hedged item ($1m of variable
debt), the first step is to determine the original cash flows associated with the hedged item.
In this case the hedge item is the cash flow variability in the BBSW interest payments on the loan.
So the original interest payments are going to be the BBSW determined cash flows at inception
of the hedge arrangement (BBSW was 7%). These are depicted above as the Original cash flows
expected at inception of the loan.

At the end of the first period, the BBSW rate has dropped to 5 per cent. Hence to determine the
change in cash payments of BBSW interest for each period it is necessary to revise the interest
payment schedule to 5 per cent. This is depicted as the revised cash flows expected on the
loan above.

To determine the cumulative change in fair value it is then necessary to compute the present
value of the original and the revised cash flows using the discount rate at the end of period 1
(5%). As interest rates have fallen over the period, the cash flows have reduced and accordingly
a gain has been made on the cumulative change in fair value (present value) of the expected
future cash flows on the hedged item ($33 314).

This gain perfectly offsets the loss on the actual swap utilised to hedge this item, as the swap
perfectly fixes the cash flows on the loan at the original BBSW rate.

The same approach is taken in each of the remaining periods.

3. Fair value calculations for the fair value hedge

We start by assuming the same facts as Example 7.8. Note that they are not repeated here.
The fair values utilised in the effectiveness test for each of the periods is reflected in Table A7.6.
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 460 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Table A7.6

Ratio offset

Period 1 2 3 4 5 6 7 8

Fair value debt E –1 024 985 –1 007 121 –1 018 067 –1 004 818 –996 378 –997 564 –996 324 0

Fair value swap F 24 985 7 121 18 067 4 818 –3 622 –2 436 –3 676 0

Change in value

Debt E –24 985 17 864 –10 945 13 249 8 440 –1 187 1 241 –3 676

Swap F 24 985 –17 864 10 945 –13 249 –8 440 1 187 1 241 3 676

Ratio offset E/F 100% 100% 100% 100% 100% 100% 100% 100%

We found that there was 100 per cent effectiveness in the offset in the fair value of the debt and
the swap. Table A7.7 depicts the fair values at the end of period 1.

Table A7.7

End of Discount
period 1 rate 5.00%

1 2 3 4 5 6 7

Notionals Rec 16 250 16 250 16 250 16 250 16 250 16 250 1 016 250

Notionals Pay 12 500 12 500 12 500 12 500 12 500 12 500 1 012 500

PV Rec 1 024 985 16 049 15 851 15 656 15 462 15 271 15 083 931 613

PV Pay 1 000 000 12 346 12 193 12 043 11 894 11 747 11 602 928 175

Fair value of swap 24 985

The swap is computed in the same fashion as the swap in the cash flow hedge example reflected
previously in section 1 of this appendix. The numbers differ given the different nature of the
swap but the approach is exactly the same. Hence the approach is not repeated in this section.
Table A7.7 highlights the calculation of the swap for the first period.

The focus of this section is on the fair value change in the debt. This fair value change in the debt
is calculated in the same fashion as the receive leg of the swap. We start by determining the fixed
cash flows being hedged. In this case we are told that the benchmark interest of 6.5 per cent
is being hedged. The benchmark interest rate was 6.5 per cent at inception and accordingly at
inception the fair value of the 6.5 per cent fixed rate loan would have been exactly $1 000 000.
This is because when you discount a coupon bearing loan by the same rate you will derive the
initial face value of the debt.

The change in the fair value of the debt is simply the change from the inception present value of
$1 000 000 to the current value. In the example above at the end of the first period the discount
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rate has reduced to 5 per cent, with the result that the present value of the loan at the new
discount rate has increased by $24 985. This is a loss as the loan (a liability) has increased in
present value terms.

It should be noted that the loan terms and interest rate will not always match the receive leg of
the swap so it is necessary that this calculation is done independently from the fair value of the
swap. Likewise it should be noted that while the loan is adjusted for fair value changes for the
designated hedged risk (in this case benchmark interest rate risk) the loan is not at fair value as it
has not been adjusted for all risk attributes that impact the loan’s fair value.
 Suggested answers | 461

Suggested answers
Suggested answers

Question 7.1
The auditors are correct in stating that IFRS 13 requires ‘own credit’ risk to be taken into account
in the value of derivatives in a liability position. While there has always been an obligation to
take credit risk into account in computing fair value in respect of derivatives, this was frequently
ignored in respect of derivative liabilities, on the basis that the definition under IAS 39 requires
the fair value on a settled basis. This has been clarified under IFRS 13 by a change in the
definition of fair value. Specifically, IFRS 13 requires that liabilities be valued on ‘transfer’ basis
rather than a ‘settled’ basis, as is the case under IAS 39.

Question 7.2
Yes, the CFO should be concerned because the accounting treatment for derivatives depends
on whether or not the derivative is in a hedge relationship. If the derivative is not in a hedge
relationship, it must be fair valued on the balance sheet and subsequent changes in fair value
recorded in the profit and loss account. If the derivative is in a hedge relationship, it is possible
to either: (i) offset the derivative gain or loss with a similar gain or loss on the underlying hedged
item in a fair value hedge; or (ii) defer the hedge gain or loss in a hedge reserve account until
the underlying hedged item is reflected in the profit and loss account. There are specific rules,
including formal documentation, to achieve hedge accounting. Hence, the company’s position
deserves serious consideration to ensure the desired accounting treatment is achieved.

Question 7.3
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(a) There are two exceptions to the rule that a hedge must be used in the hedge relationship
in its entirety, namely where:
(i) IAS 39 permits the time value in the derivative to be excluded from the hedge
relationship in forward contracts and options; and
(ii) a hedge can be split proportionately.
 462 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

(b) Sold options are permissible hedge items only when they are part of a collar arrangement
from inception. Hence, sold options can never be used on their own in a hedge relationship.

(c) Under IAS 39, the company cannot split derivatives on a time-period basis.

(d) IAS 39 allows a company to split a derivative on a proportionate basis. For example,
a company can document a forward exchange contract such that 50 per cent is in a hedge
relationship and 50 per cent is treated as trading.

Question 7.4
A forecast transaction can be a hedged item in an IAS 39 hedging relationship but the forecast
must be highly probable. In a mining environment, this could depend on the verifiable reserves,
the ability of the company to extract those reserves and the reliability of the timing of the
extraction. There would need to be convincing evidence from experts in the gold industry
that the reserves exist, the company has access to adequate funding and there are no undue
complexities in extracting them from the ground. Furthermore, it would be expected that there
is a conservative buffer in the quantum of gold being hedged; for example, if gold production is
expected to be 1000 ounces per month, there should be a reasonable buffer in the quantum of
the hedge—say, 50 per cent.

Question 7.5
(a) Hedges of forecast transactions are always cash flow hedges.

(b) Given that the hedge was ‘highly effective’, the gain should be deferred in equity until the
sale is recognised in the profit and loss statement.

(c) Yes, any gains or losses hedging a forecast transaction must be written off to the profit and
loss if the forecast is no longer likely to occur.

(d) As the fair value of the debt will increase or decrease depending on interest rate changes,
the derivatives will hedge the fair value changes. Hence, the hedge will be a fair value hedge.

(e) Gains and losses on a derivative in a cash flow hedge of a non-financial item can be
transferred from equity to inventory on booking the inventory in the accounts.

(f) A hedge of variable-rate debt with an interest rate swap will be a cash flow hedge. The hedge
instrument converts variable interest payments to fixed interest payments.

Question 7.6
(a) Derivative gains and losses on a hedge of a net investment in a foreign operation are, to the
MODULE 7

extent that the hedge is effective, recorded directly in equity in the consolidated accounts
(as part of the consolidation journals).

(b) Yes, net investment hedges are subject to the same rules in IAS 39 as all other hedges.
 Suggested answers | 463

(c) When a company hedges a balance sheet asset or liability with a forward exchange contract,
the company would normally exclude the time value in the forward exchange contact to
improve the hedge relationship. The time value component will be fair valued and taken to
the profit and loss every period. When the company hedges a forecast transaction, the time
value component can be included or excluded in the hedge relationship. A net investment
hedge can be considered as a balance sheet hedge of the net investment or a hedge of the
forecast sales proceeds of the net investment. Depending on the approach taken, the time
value could be included or excluded from the hedge relationship.

Question 7.7
(a) To be considered ‘highly effective’, the ratio of changes in fair value of the derivative to
the hedged item must be in a range of 80 per cent to 125 per cent.

(b) A hedge will be ‘highly effective’ if, at inception and throughout the life of the hedge,
the change in fair value of the hedge offsets the change in fair value of the hedged item
for the attributable risk in a range of 80 per cent to 125 per cent. Hence, using the dollar
offset calculation for the period, effectiveness is determined by:

2600 / 2350 = 111%

As the 111 per cent is within the range of 80 per cent to 125 per cent, the hedge is highly
effective for the period.

(c) There is no single method prescribed, so each company must determine and document its
own method for assessing effectiveness. Typically, companies will use the matched terms,
dollar offset or regression methods.

(d) Any ineffectiveness in a hedge must be recorded in the profit and loss immediately.

Question 7.8
(a) See the section ‘Hedge documentation’ for details. At inception, the formal documentation
should include the following:
(i) identification of the hedging instrument;
(ii) identification of the hedged item;
(iii) risk management objective and strategy;
(iv) nature of the risk being hedged;
(v) how the entity will assess the hedge’s effectiveness;
(vi) if the hedged item is a forecast transaction, the basis for it being considered
highly probable;
(vii) assessment of the hedge’s effectiveness at inception; and
(viii) comment that time value is included or excluded.
MODULE 7

(b) No. A company cannot retrospectively correct the hedge documentation. The company
could achieve hedge accounting prospectively from when the formal documentation is put
in place.
 464 | ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

Question 7.9
The forward element is the difference between the USD notional amount converted at the
forward rate and the spot rate. In this example, the forward element is AUD 47 281, calculated
as follows:

USD notional amount converted at forward rate = AUD 1 111 111

less USD notional amount converted at spot rate = AUD 1 063 830 (i.e. USD 1 000 000 / 0.94)
AUD 47 281

The new hedge accounting model requires that the forward element be allocated to each period
using a systematic and rational process (possibly a straight-line amortisation approach) over
the period during which the hedged item is expected to affect the P&L. As the hedge covers a
two-year period, the forward points should be allocated over the two-year period. A straight-
line basis could be used and hence the first year should be allocated 50 per cent of the forward
element, or $23 640.50. As the AUD forward rate is at a discount to the spot rate (i.e. there is a
cost to hedging forward), this will result in an expense to the P&L each year.

Question 7.10
(a) The IFRS 9 new hedge accounting model removes the retrospective hedge effectiveness
test as well as the rigid threshold of 80 per cent to 125 per cent that exists in IAS 39.
Hence, the 126 per cent effectiveness ratio doesn’t cause an automatic failure in the hedge
relationship. However, the 126 per cent result would likely cause the IFRS 9 prospective
qualitative hedge effectiveness criteria to fail in the next period.

Fortunately, IFRS 9 provides an automatic rebalancing feature such that when the
organisation’s hedge relationship no longer satisfies the hedge ratio criterion—but its risk
management objective remains the same for the hedge relationship—the organisation must
adjust the hedge ratio so that it meets the hedging criteria prospectively. So, in this instance,
26 per cent of the hedge item would be de-designated from the current hedge relationship,
and the remaining 100 per cent of the hedge instrument would continue in the original
hedge accounting relationship.

(b) An aggregated exposure is where a derivative is aggregated together with the non-derivative
hedged item to create a new hedge item. Common examples are:

Derivative + Hedge item = Aggregate exposure

Cross currency interest rate Foreign currency borrowing Synthetic local currency
swap borrowings

Commodity swap Highly probable forecast Foreign currency proceeds

sales of commodity

Interest rate swap to floating Local currency debt fixed Synthetic floating rate debt
MODULE 7
 FINANCIAL RISK MANAGEMENT

Module 8
CONTROLLING RISKS
JOHN KIDD*

* The author acknowledges the contributions of Richard Allan and Anthony Persico
to previous editions of this module.
 466 | CONTROLLING RISKS

Contents
Preview 467
Introduction
Objectives
Teaching material
Culture of financial risk management 468
Risk management framework 470
Responsibilities and obligations of directors
Responsibilities and obligations of CFOs and corporate treasurers
Management responsibilities
Establishment and functions of a risk committee
ASX Principles on good governance
Case study in financial risk control management 476
Internal control framework 477
Control environment
Effectiveness of internal control
Controlling financial risks
Regulations 483
ASX principles on internal control
Australian Prudential Regulation Authority (APRA) regulations
Australian Securities and Investments Commission (ASIC) regulations
US regulations: Sarbanes–Oxley Act 2002
Governance framework for financial risk management 484
Governance structure
Financial risk management policy
Financial risk management policy—key risks and controls
Scope and content of board reports
Need for procedures
Operational risks 508
Operational risk—definition and objectives
Segregation of duties
Process and system risk
Business continuity issues
Accounting disclosure requirements 512
Risk management disclosures
Review 522

Appendix 523
Appendix 8.1 523

Reading 537
Reading 8.1 537

Suggested answers 541

References 545
Optional reading
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Module 8:
Controlling risks
Study guide

Preview
Introduction
This module builds on the discussion in Module 1 and specifically focuses on the implementation
of controls to manage financial risks and associated operational risks to which an organisation
may be exposed. Accordingly, this module covers the key risk management principles, the roles
and responsibilities of key executives, the normal financial risks that organisations are exposed
to, and the controls that are normally implemented to address the various risks. Typical financial
risks include liquidity and funding risk, market risk (foreign exchange, interest rates, commodity
prices), credit risk, operational and legal risk.

Controlling risk generally involves aiming to achieve an appropriate balance between realising
opportunities for gains while minimising losses. It is an integral part of good management
practice and an essential element of good corporate governance. It is an iterative process
consisting of steps that, when undertaken in sequence, enables continuous improvement in
decision-making and facilitates continuous improvement in performance.

To be most effective, risk management should become part of an organisation’s culture. It should
be embedded into the organisation’s philosophy, practices and business processes rather than
be viewed or practised as a separate activity. When this is achieved, everyone in the organisation
becomes involved in the management of risk.

The adoption of consistent processes within a comprehensive framework helps ensure that risk
is managed effectively, efficiently and coherently across an organisation. It is recommended
that organisations have a framework that integrates the process for managing risk into the
organisation’s overall governance, strategy and planning, management, reporting processes,
policies, values and activities.
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Objectives
At the end of this module you should be able to:
• explain the importance of recognised frameworks for risk management and internal control
and how these might be utilised;
• explain the regulatory requirements that apply to organisations;
• identify and explain the key elements of an effective governance framework for financial
risk management;
• explain the key controls over financial risks;
• using a practical example that is provided, evaluate controls over derivatives in a corporate
environment; and
• explain an organisation’s financial risk management framework and create a board report to
reflect the organisation’s exposures and risk appetite.

Teaching material
• International Financial Reporting Standards (IFRS)
IFRS 7 Financial Instruments: Disclosures

• Reading
Reading 8.1
‘How sons of Lalor built, then sank, Sons of Gwalia’
M. Drummond

Culture of financial risk management

A culture of risk management must start from the top of the organisation. This is achieved by the
example that the board sets, and its interaction with management through rewards for building
a risk-intelligent culture.

Risk management in many organisations is often seen as a negative—to restrict certain actions.
But this is a misconception as it is accepted in business that it is essential to take risks to make
profits. The governance of risk and value creation should therefore be considered as one and the
same thing.

Every decision, activity and initiative that aims to create value has a degree of risk. Accordingly,
risk management is about understanding the material risks faced by the organisation, and ensuring
that they are appropriately managed in line with the board’s risk appetite. Hence, managers should
seek to embed a culture of risk management throughout the organisation, such that understanding
and considering risk before taking action or setting policy becomes integral to the organisation’s
psyche. Rather than being risk averse then, the organisation is risk intelligent.

The adoption of a sound risk management culture within an organisation plays an important role
in determining the behaviour of individuals and their attitudes towards risk. Often employees’
behaviours towards risks will be derived from the risk management culture incorporated within
the organisation. It is highly important that organisations identify the impact of employees’
behaviour towards risks as this ultimately determines if risks are being identified appropriately
within all levels of the organisation. In instances in which an organisation’s risk management
culture is seen to be weak, the organisation will notice a higher instance of dysfunctional
behaviour of individuals towards risk management. In these cases employees will often make
key business decisions without being aware of the potential risks that they involve.
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Often it is the tone set by senior staff towards the risk management culture within an organisation
that will determine the behaviours of employees towards identifying and assessing risks. If senior
management adopts a carefree attitude towards the risk management process, this will flow down
through the organisation. Organisations that value risk management and implement it through
the actions of senior management will notice a significant improvement in the behaviours of
employees towards risks.

The recent Libor scandal provides an example of a breakdown in culture. In this scandal, major
financial institutions were found to have provided fraudulent submissions of market rates to
the British Banks Association (BBA), thereby distorting the Libor rate published by the BBA.
The Libor interest rate is a critical rate as it is utilised in the terms of interest rate derivatives that
are traded across the globe. Persons submitting the rates on behalf of the various banks were
found to have made fraudulent submissions in order to benefit their own bank, to make their
own bank look healthier than it actually was or to benefit a client with subsequent kickbacks in
the form of profitable trades. The impact of these actions has reduced the credibility of financial
markets, tarnished the reputation of the banks involved and cut short the careers of persons
involved and senior management. It resulted in significant fines to the banks involved and,
potentially, criminal proceedings being brought against certain individuals. As a result of the
scandal, the role of collecting market rates has passed to the Financial Services Authority
(FSA—the UK financial regulator), which has put in place additional controls to ensure that only
valid submissions backed by evidence can be submitted.

Examples of the impact can be seen on two specific banks, UBS and Barclays Bank. UBS was
fined USD 1.5 billion for its role in the scandal. In the case of Barclays Bank, the chairman and
CEO were forced to resign even though neither had knowledge of the fraud beforehand.
In addition, Barclays Bank was fined USD 200 million by the Commodity Futures Trading
Commission, USD 160 million by the US Department of Justice and GBP 59.5 million by the
FSA for attempted manipulation of the Libor and Euribor rates.

Needless to say, the culture of an organisation is critical in ensuring that it upholds the highest
possible standards of business ethics. As demonstrated above in the Libor scandal, the risk of
fraud is always present and may not be obvious. The three usual elements of a fraud are:
1. rationalisation (the employee’s justification for their action, such as thoughts that they are
unfairly remunerated);
2. pressure or motive (the employee may have unsustainable debts or be looking for a bonus); and
3. opportunity (a situation exists that provides the employee the ability to commit the fraud).

While rationalisation and pressure may be difficult if not impossible to manage, a strong culture
with a focus on business ethics (e.g. removing performance targets that conflict with sustainable/
ethical business operations) can help to diffuse these elements. Further, specific risks of fraud
should be identified and robust risk management and internal controls should act to eliminate
the opportunity.
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Risk management framework

Figure 1.2 of Module 1 outlines the core five steps in the financial risk management process:
1. Establish the context.
2. Identify risk.
3. Analyse risk.
4. Evaluate risk.
5. Treat risk.

Around these steps are feedback and control lines to:

• monitor and review; and
• communicate and consult.

This module emphasises the importance of governance and financial risk management policy.
It also stresses the need to regularly monitor, review and communicate financial risk management
processes throughout the organisation and with stakeholders, and explores in some depth the
controls needed to manage financial risks. It should be remembered that all these financial
risk management activities must be seen in the context of the objectives and mission of
the organisation.

The degree of formality in a risk framework and controls environment depends on a combination
of the complexity and size of the operation, the regulatory environment and the degree to which
there is public ownership. Listed companies in Australia, for example, would normally have a
formal risk management framework and control environment under the Corporate Governance
Principles and Recommendations (ASX Principles) (ASX CGC 2014) that are produced by the
Corporate Governance Council (CGC) of the Australian Securities Exchange (ASX).

The ASX Principles are not prescriptive. If a listed entity considers that particular
recommendations are not appropriate to its circumstances, it has the flexibility not to adopt
them, as long as it explains why it has done so.

Principle 7 of the ASX Principles states:

A listed entity should establish a sound risk management framework and periodically review the
effectiveness of that framework (ASX CGC 2014, p. 4).

Whether or not an organisation is listed, most boards recognise the importance of managing
the organisation’s financial risks, and should regularly document, monitor and review their key
policies for doing so. Boards must ensure that, throughout the organisation, risks are clearly
communicated and understood, and risk management techniques and permitted delegated
authority are recognised. In particular, it is important that boards understand their roles,
the regulatory requirements and the on-going reporting obligations, and that robust and
well‑designed internal risk management controls operate effectively.

Responsibilities and obligations of directors

Directors’ duties are prescribed by the Corporations Act 2001 (Cwlth) and other legislation,
and may also arise from common law. The general obligations of directors include the following:
• Duty of care and diligence—directors must acquire and maintain a reasonable level of
competence. However, they are not expected to have a greater degree of skill than would
reasonably be expected of persons with their knowledge and experience.
• Fiduciary duty to act in good faith for the benefit of the shareholders.
• Avoiding improper use of information and position.
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Directors are personally liable if they allow a company to trade when insolvent. Responsibilities
of directors that relate to financial risk management can be broadly classified into the following
categories:
• Legal obligations imposed by specific sections of the Corporations Act 2001 (Cwlth).
• Regulatory requirements and guidance notes of ASIC and reporting rules of the ASX.
Companies listed on offshore exchanges may also have to comply with local regulations in
those jurisdictions.
• Subsidiaries of foreign companies may also have to comply with regulations of the parent
country. For example, subsidiaries of US companies operating in Australia may have to
comply with US Securities and Exchange Commission (SEC) regulations.
• Internal requirements relating to the conduct of the board in directing the company’s financial
affairs and working with management.

Legal obligations
Directors are expected to exercise adequate duties of care, skill and diligence and to take
appropriate steps to inform themselves about relevant issues. With respect to financial
risks, they must understand what major risks the company faces and satisfy themselves that
appropriate processes are in place to manage those risks. They should decide what risk
management information is to be included in reports to shareholders, including the statutory
accounts. They must make fair and honest decisions on the basis of the available information.

Although directors are entitled to rely on management to conduct the day-to-day business,
that reliance does not absolve directors from the responsibility of ensuring that policies are
established and are operating effectively. The reporting regime must ensure that directors
are promptly informed of any current or potential financial difficulties.

Directors should ensure that staff have experience and knowledge commensurate with the
complexity of the financial instruments they are authorised to use. There must be appropriate
training and effective ways of assessing the competence of management and staff to deal with
financial instruments.

Other obligations
Directors should also ensure that:
• there are no unrealistic profit targets or staff performance expectations that might lead to
excessive risk-taking;
• remuneration is not awarded on the basis of recorded results regardless of the risks to which
the business is exposed; and
• staff are not able to conceal losses while undertaking greater risks in order to try to recover
ground.

Board audit committee

ASX Listing Rule 12.7 requires a company that is listed in the S&P All Ordinaries Index at the
beginning of the year to have an audit committee during the year. If the company was in the
top 300 of that index at the beginning of the financial year it must follow the ASX Principles on
the composition and operation of the audit committee, as set out in Principle 4.

The board audit committee functions as the eyes and ears of the board, as it is able to
delve much more deeply into issues than the full board (whose key roles are strategies and
governance). On behalf of the board, this subcommittee would oversee and report on all
financial and treasury activities.
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The chief financial officer (CFO) should prepare a periodic report summarising current financial
risk management strategies in relation to funding and the management of operational risk,
liquidity and interest rate risk, foreign exchange risk, commodity risk and counterparty risk for
presentation to the board audit and finance committee, including any pertinent issues raised by
the risk management committee. This report should also include a statement to the effect that
all treasury risk management policies have been complied with throughout the period, or an
explanation of the circumstances surrounding non-compliance.

The role of audit committees in both corporate governance and risk management is discussed in more
detail in the ‘Ethics and Governance’ subject of the CPA Program.

Responsibilities and obligations of CFOs and corporate treasurers

Where companies have a CFO and/or a corporate treasurer, they would usually be considered
executive officers and, therefore, are required under the Corporations Act 2001 (Cwlth) to meet
the duties of an officer of the corporation. These duties include:
• acting honestly;
• using reasonable care and diligence; and
• avoiding improper use of information and position.

One of the areas where financial risk managers need to be particularly diligent is in the
application of the corporation’s cash to separate legal entities. In times of increasing automation
in cash management, it is important for risk managers to determine the amount of financial
resources required by each legal entity within a corporation and to ensure that the board is aware
of any unusual demands on financial resources.

Management responsibilities
Chief executive officer
The chief executive officer (CEO) is responsible for the day-to-day running of the business. It is up
to the CEO to translate the broad policies developed and approved by the board and ensure they
are put into operation. The CEO is responsible to the board collectively, not to the chairperson
alone. Depending on the delegations of authority from the board, it is likely that the CEO will be
required to authorise any short-term increases in risk limits or limit breaches (including the remedial
action required to fix the breach). The CEO is usually a business specialist, not necessarily a finance
specialist. However, the CEO should be capable of asking sufficient questions to understand the
impact of financial issues on the business.

Chief financial officer

The chief financial officer (CFO) is responsible for the financial operations of the business.
As noted in Module 1, their primary responsibility is managing the financial risks of the
organisation. The CFO is also responsible for financial planning and record-keeping, and for
financial reporting to higher management. The CFO supervises the finance unit and is the chief
financial spokesperson for the organisation. This usually includes statutory reporting (financial
accounts), internal reporting (management accounting), taxation, internal audit and treasury
operations. Internal audit often reports directly to the board so that audit staff cannot be
influenced by the CFO in reporting their findings. In this way they retain their independence.
The CFO’s role may also include other areas such as information technology, legal services,
human resources and marketing. CFOs will have a sound understanding of finance and risk
management issues, even if their background does not include treasury experience. The CFO
will usually have a large influence in the development of the appropriate financing and risk
management strategies within the company.
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Establishment and functions of a risk committee

Management is responsible for laying the foundation for monitoring and reviewing the
organisation’s risk management framework. The role of management is to ensure that controls
are effective and efficient in both design and operation, obtaining further information to
improve risk assessment and analysing the lessons learnt from events such as successes
and failures. It is vital for management to be aware of changes in the external and internal
context of risk, including changes to risk criteria and the risk itself, which may require revision
of risk treatments and priorities. Identification of emerging risks is also a crucial part of
management’s responsibilities.

The organisation’s risk management framework should be designed to enable the board to
provide strategic guidance and effective oversight of management. This usually involves the
board providing input into the final approval of management’s monitoring systems of risk
management and internal control.

Most large organisations have a risk management committee that is a subcommittee of the
board of directors. The role of the committee is to make recommendations to the board with
respect to risk management policies, including limits, delegations of authority, risk quantification
and reporting methodologies, performance measurement and other risk management issues.

Where the risk committee is responsible for financial matters, it will typically have authority
delegated from the board to approve and monitor strategies pertaining to:
• funding and liquidity management;
• interest rate risk management;
• foreign exchange risk management;
• commodity price risk management; and
• funding arrangements.

The role of the committee would be to consider strategies recommended by the CFO. Typically,
the committee should meet on a monthly basis to discuss a number of issues including:
• assessing views on current and future market conditions;
• reviewing funding and liquidity needs;
• reviewing interest rate exposures;
• reviewing foreign exchange exposures;
• reviewing commodity price exposures;
• determining short- and long-term risk management strategies to manage these exposures;
• reviewing recent transactions and results;
• reporting on any breaches that may have occurred; and
• recording and minuting decisions and rationales.

Another type of committee is a corporate finance subcommittee which works in conjunction

with the risk committee. Typically, the corporate finance subcommittee should meet monthly to
discuss a number of issues including:
• overseeing investment policies and strategies;
• reviewing performance of the investment portfolios of the organisation;
• reviewing and provide guidance to the board about potential mergers and acquisitions; and
• overseeing the capital structure and the corporate finance strategy and activities.

In smaller organisations, the role of the risk management committee will normally be undertaken
by the board audit committee.

Reading 8.1—‘How sons of Lalor built, then sank, Sons of Gwalia’, reports on the historic company’s
collapse. You should review Reading 8.1 now.
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ASX Principles on good governance

The ASX Corporate Governance Council was created to develop and deliver an industry-wide,
supportable and supported framework for corporate governance with a practical guide to listed
companies. The council has developed and published eight principles designed to meet this aim
and to promote good governance, which will in turn encourage companies to create value and
provide accountability and control systems commensurate with the risks involved. The council’s
latest publication is the ASX Principles, as mentioned earlier. ASX‑listed companies are obligated
to disclose the extent to which they have not followed the recommendations and their reasons—
the ‘if not, why not?’ approach. Needless to state, these are sound principles for governing any
organisation.
Principle 1. Lay solid foundations for management and oversight: A listed entity should
establish and disclose the respective roles and responsibilities of its board and management and
how their performance is monitored and evaluated.
Principle 2. Structure the board to add value: A listed entity should have a board of an
appropriate size, composition, skills and commitment to enable it to discharge its duties effectively.
Principle 3. Act ethically and responsibly: A listed entity should act ethically and responsibly.
Principle 4. Safeguard integrity in corporate reporting: A listed entity should have formal and
rigorous processes that independently verify and safeguard the integrity of its corporate reporting.
Principle 5. Make timely and balanced disclosure: A listed entity should make timely and
balanced disclosure of all matters concerning it that a reasonable person would expect to have a
material effect on the price or value of its securities.
Principle 6. Respect the rights of security holders: A listed entity should respect the rights of
its security holders by providing them with appropriate information and facilities to allow them to
exercise those rights effectively.
Principle 7. Recognise and manage risk: A listed entity should establish a sound risk management
framework and periodically review the effectiveness of that framework.
Principle 8. Remunerate fairly and responsibly: A listed entity should pay director remuneration
sufficient to attract and retain high quality directors and design its executive remuneration to
attract, retain and motivate high quality senior executives and to align their interests with the
creation of value for security holders (ASX CGC 2014, p. 4).

More specifically, Principle 7 makes the following four main recommendations.

Recommendation 7.1. The board should have a risk committee to review and make
recommendations to the board in relation to:
The board of a listed entity should:
(a) have a committee or committees to oversee risk, each of which:
(1) has at least three members, a majority of whom are independent directors; and
(2) is chaired by an independent director,
and disclose:
(3) the charter of the committee;
(4) the members of the committee; and
(5) as at the end of each reporting period, the number of times the committee met
throughout the period and the individual attendances of the member at those meeting; or
(b) if it does not have a risk committee or committees that satisfy (a) above, disclose that fact
and the processes it employs for overseeing the entity’s risk management framework
(ASX CGC 2014, p. 28).
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Recommendation 7.2. The board or a committee of the board should:

(a) review the entity’s risk management framework at least annually to satisfy itself that it continues
to be sound; and
(b) disclose, in relation to each reporting period, whether such a review has taken place
(ASX CGC 2014, p. 29).

Recommendation 7.3. A listed entity should disclose:

(a) if it has an internal audit function, how the function is structured and what role it performs; or
(b) if it does not have an internal audit function, that fact and the processes it employees for
evaluating and continuously improving the effectiveness of its risk management and internal
control processes (ASX CGC 2014, p. 30).

Recommendation 7.4. A listed entity should disclose whether it has any material exposure to
economic, environmental and social sustainability risks and, if it does, how it manages or intends to
manage those risks (ASX CGC 2014, p. 30).

Small-mid market capitalised guide to recognise and manage risk

The ASX Markets Supervision Education and Research Program put out a Guide for Small-Mid
Market Capitalised Companies (2009) on how such companies might comply with Principle 7.
The guide states that there is a stakeholder expectation that listed companies will have
appropriate risk management frameworks in place and provides templates to follow for setting
up such a framework. The actions required, as set out in the guide, are as follows:
1. Complete risk tolerance questionnaire.
2. Draft Risk Management Policy.
3. Approve Risk Management Policy.
4. Publish Risk Management Policy on the company website.
5. Review board charter and role descriptions to ensure accountability for risk is included.
6. Identify material business risks and document in the risk register in year and continue to
reassess the full list of risks in consecutive years.
7. Allocate risk owners to critical risks.
8. Manage material business risks.
9. Update the risk register or prepare individual risk reports and present to the board.
10. Prepare CEO/CFO certification.
11. Prepare a summary of the risk management activity throughout the year and present to
the board (including effectiveness statement).

In respect of financial risk management, financial risk is a major risk for all companies and
accordingly would be considered a subset of the overall risk management process described
above. This is specifically covered later in this module.

The ASX corporate governance guidelines, along with a number of international approaches to
corporate governance, are expanded on in the ‘Ethics and Governance’ subject of the CPA Program.
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Case study in financial risk control management

The much-publicised events of 2003/04 regarding the losses of the National Australia Bank (NAB)
in Australia of AUD 600 million and the 2007/08 losses of around AUD 8 billion by the Société
Générale in France illustrate the magnitude of losses that can be associated with a corporation’s
failure to properly understand and manage the risks associated with derivatives. While both were
able to contain the exposures, stakeholders suffered heavy losses because of the control failures.
However, for many organisations, the impact is terminal, to the extent that a corporation may be
forced to cease operations, as was the case for Pasminco Ltd, Barings Bank and Sons of Gwalia,
to name just three.

To determine whether these critical control failures could have been avoided, it is worthwhile for
board members, risk professionals, internal audit staff, CEOs and CFOs to analyse the events
that led to these collapses. As an example, we return to the case of Pasminco Ltd which was
discussed in Case Study 6.8.

The analysis will ascertain whether there are common lessons to be learned that can be applied
to the financial risk management activities of other organisations.

Case Study 8.1: Pasminco

Pasminco was a major lead- and zinc-mining company that supplied more than 8 per cent of global
demand for finished zinc and lead metal. In September 2001, Pasminco was placed in voluntary
administration with debts of around AUD 3.4 billion after declining cash flows from its core businesses
and mounting unrealised losses on its foreign exchange hedge book caused financial distress.

After attempts to divest Pasminco’s major non-smelting assets to repay debt had proved unsuccessful,
the administrator undertook a corporate restructure to extract value for creditors.

The administrator’s interim report to creditors in March 2002 identified three main factors that
contributed to Pasminco’s demise:
1. A marked decline in the zinc price affected unhedged commodity sales values (cash flows) and
asset values.
2. Pasminco carried too much debt. This was a result of its acquisition of Savage Resources, the
development of its Century Mine, and the losses on its pre-existing foreign exchange hedge book
increasing to around AUD 840 million.
3. Savage Resources’ assets performed below projected estimates at the time of the assets’
acquisition, resulting in reduced operating cash flows.

The decision to hedge only the foreign exchange exposure on commodity cash flows (not the zinc
price itself) left Pasminco’s cash flows vulnerable to declining zinc prices and a declining AUD/USD
exchange rate. Had the exchange rate not been fixed, the company would have benefited from the
falling exchange rate when the commodity prices fell. Had the commodity price been fixed, the
company may have further reduced its losses. Ultimately, the combination of these market factors
undermined the ability of the company to service its debt and fund major capital works on new projects.

Pasminco hedged the FX exposure at a high exchange rate, but did not hedge the commodity price
exposure.
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The currency hedge was based on a high commodity price which then dropped significantly.
Unfortunately the exchange rate also dropped at the same time. This meant that the US proceeds
the company had hedged for currency risk no longer existed, so the company then had excessive
currency hedges which needed to be closed out. As the AUD had dropped at the same time, a loss
was incurred on the currency hedges.

The company was in the worst possible situation: a hedged AUD position at a high rate and a declining
commodity price.

If Pasminco hadn’t hedged its currency book, it would have benefited from the declining AUD/USD
exchange rate, with zinc being priced in USD. On the reverse side, if it had hedged its zinc price,
it wouldn’t have experienced the falls in the price, and may have also had sufficient proceeds to meet
its FX hedge commitments.

Scenario or risk analysis is the cornerstone of informed decision-making. Boards should understand
and assess the impact of proposed hedging strategies on cash flow volatility, financial flexibility
and, ultimately, on achieving corporate objectives across a range of adverse and improbable
market conditions. A fundamental step in assessing the commercial risks to shareholders is to
ask ‘What if …?’ questions in the event that assumed outcomes underlying the strategy do not
occur as expected. Appropriate risk management by the Pasminco board would have identified
the risks and implemented an appropriate risk treatment plan, and monitored the plan to ensure
the controls were operating effectively. Had such analysis been performed, the collapse may have
been avoided.

Internal control framework

Control environment
Evaluating controls and implementing better controls are essential parts of the risk
management process.

Company directors and senior managers have long sought ways to better control the
organisations they run. Internal controls are put in place to enable companies to achieve
their business objectives, and to minimise unwanted surprises along the way. In addition,
internal controls promote efficiency, reduce the risk of asset loss, and help ensure the reliability
of financial statements and compliance with laws and regulations.

In Module 1, controls were defined as any action that reduces risk. Internal control is more
specifically defined as a process, implemented by a company’s board of directors, management
and other personnel, designed to provide reasonable assurance regarding the achievement of
objectives in the following categories:
• effectiveness and efficiency of operations;
• reliability of financial reporting; and
• compliance with applicable laws and regulations.

The level of risk and control documentation needed to support company controls will vary
depending on the industry and specific regulatory requirements, the board of directors and
the size of the company. As all financial risk management activities have a direct impact on the
financial statements, this module focuses on the reliability of financial reporting.
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The ultimate objective for the documentation of an internal control process is to assist in a
meaningful and informed evaluation of financial risks and controls. Documentation should be
sufficient to:
• where relevant, identify the financial statement accounts affected by the process being
documented;
• provide information on how transactions are initiated, authorised, recorded, processed
and reported;
• identify all key decision points within a process;
• provide information about each type of transaction and the flow of transaction activity to
identify where material misstatements arising from error or fraud could occur;
• evidence the identification of controls and the communication of responsibility for
performing those controls;
• confirm the alignment of risks and controls;
• distinguish between key controls and other controls identified;
• indicate the steps to be undertaken should the controls identified detect a failure or an
exception within the process;
• confirm the identification of changes to internal control processes or environment;
• provide information on the IT systems used in the management and/or derivation of
financial information (i.e. general ledger, spreadsheets, other IT applications) and clarify
the interface, within the control environment between finance and IT systems; and
• verify handover points between service providers within the company.

The level of documentation of control should be commensurate with the risks involved.
Accordingly, you would expect better internal control documentation over those areas identified
as high risk, such as financial risk management and in particular, controls over the use of board-
approved derivatives.

Committee of Sponsoring Organizations of the Treadway Commission (COSO)

The Committee of Sponsoring Organizations of the Treadway Commission (COSO)
(an independent private sector initiative) was established in 1985 to analyse the causal factors
that can lead to fraudulent financial reporting and developed recommendations for public
companies and their independent auditors for the US SEC and other regulators.

COSO developed a framework to assist the managers of companies and other businesses to
better control their organisations’ activities. COSO integrated various internal control concepts
into a framework in which a common definition is established and control components are
identified. In 2013, a framework (COSO 2013) was released to broaden the application of internal
control in addressing operations and reporting objectives, and to clarify the requirements for
determining what constitutes effective internal control. Many large Australian companies will use
COSO as a basis for establishing a sound system of internal control.

The COSO framework is an extension of the risk management process explained in Module 1
and earlier in this module—it focuses on the core ingredients to ensure a robust system of
internal controls. Fundamental to the COSO framework is the proposition that internal control
consists of five interrelated components. These are derived from the way management runs a
business, and are integrated with the management process. The components are as follows:
• Control environment. The core of any business is its people, who act according to attitudes
that reflect the environment in which they operate, including integrity, ethical values and
competence. They are the engine that drives the entity and the foundation on which
everything rests.
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• Risk assessment. The entity must be aware of and deal with the risks it faces. It must set
objectives integrated with sales, production, marketing, financial and other activities so
that the organisation is operating in concert. It must also establish mechanisms to identify,
analyse and manage the related risks.
• Control activities. Control policies and procedures must be established and executed to
help ensure that the actions identified by management as necessary to address risks are
effectively carried out.
• Information and communication. Surrounding these activities are information and
communication systems. These enable the company’s people to capture and exchange the
information needed to conduct, manage and control its objectives.
• Monitoring activities. The entire process must be monitored, and modifications made as
necessary. In this way, the system can react dynamically, changing as conditions warrant.

These five components are illustrated in Figure 8.1.

Figure 8.1: COSO Cube—five components of internal control and their linkages

ns in
g nc
e
io t ia
r at or pl
pe p m
O Re Co
Function

Control environment
Operating unit
Division

Risk assessment
Entity

Control activities

Information and communication

Monitoring activities

Source: COSO 2013, ‘Internal control—Integrated framework: Executive summary’, COSO, p. 6

accessed August 2013, http://www.coso.org/documents/COSO%202013%20ICFR%20
Executive_Summary.pdf.

The model depicts the dynamism of internal control systems. For example, the assessment of risks
not only influences the control activities, but also may highlight a need to reconsider information
and communications needs, or the company’s monitoring activities. Thus, internal control is not a
serial process, where one component affects only the next. It is a multidirectional iterative process
in which almost any component can and will influence another. The 2013 framework introduces
17 principles and a definition of the effectiveness of internal control, as shown in Table 8.1.
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Table 8.1: 17 principles aligned with related control components

Control Information and Monitoring

environment Risk assessment Control activities communication activities

1. Demonstrates 6. Specifies 10. Selects and 13. Uses relevant 16. Conducts
commitment suitable develops information. ongoing and/
to integrity and objectives. control or separate
ethical values. activities. evaluations.

2. Exercises 7. Identifies and 11. Selects and 14. Communicates 17. Evaluates and
oversight analyzes risk. develops internally. communicates
responsibility. general deficiencies.
controls over
technology.

3. Establishes 8. Assesses fraud 12. Deploys 15. Communicates

structure, risk. through externally.
authority, and policies and
responsibility. procedures.

4. Demonstrates 9. Identifies
commitment to and assesses
competence. significant
change.

5. Enforces
accountability.

Source: COSO 2013, ‘Internal control—Integrated framework: Executive summary’, COSO, pp. 6–7,
accessed August 2013, http://www.coso.org/documents/COSO%202013%20ICFR%20
Executive_Summary.pdf.

Effectiveness of internal control

In an effective system of internal control under the 2013 Framework:
1. Each of the five components and relevant principles are required to be present and functioning.
– Present is defined as ‘the determination that components and relevant principles exist
in the design and implementation of the system of internal control to achieve specified
objectives.’
– Functioning is defined as ‘the determination that components and relevant principles
continue to exist in the conduct of the system of internal control to achieve specified
objectives.’
2. The five components are required to operate together in an integrated manner.
– Operating together refers to ‘the determination that all five components collectively
reduce, to an acceptable level, the risk of not achieving an objective.’
– Management can demonstrate that components operate together when:
– The ‘components are present and functioning.’
– ‘Internal control deficiencies aggregated across components do not result in the
determination that one or more major deficiencies exist’ (Burns & Simer 2013, p. 3).
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Controlling financial risks

Risks and assertions for financial statements
For each financial statement item (e.g. derivative account in the statement of financial
position), there are various risks that could result in a misstatement in the financial statements
(see Table 8.2). These risks should be carefully considered in respect of financial instruments,
particularly derivatives, as:
• accounting concepts for derivatives are complex;
• significant judgment may be required (i.e. embedded derivatives);
• certain derivatives are difficult to value; and
• there is always a risk of fraud with derivatives and unintentional misstatements.

Table 8.2: Source of financial statement risk

Source Action required

Accounting principles Where the transactions/account balances are dependent on specific

accounting principles, explain what they are.

Judgments and estimates Identify the areas of judgment that must be exercised and the estimates
that must be made.

Reality Identify any particular features of the transaction types being processed that
cause difficulty in order to ensure all aspects of the transactions are properly
accounted for.

Fraud Intentional misstatement/non-disclosure/incorrect disclosure.

Error Unintentional misstatement.

To protect against the various identified risks, management should consider whether there are
appropriate controls in place to ensure that potential errors do not occur. These errors have
been divided into six different categories (or assertions), as different controls will often be
required, depending on the assertion that the control seeks to address (see Table 8.3). If controls
are appropriately constructed to prevent the potential errors, the risk of misstatement to any
one account balance should be substantially reduced.

Table 8.3: Financial statement assertions being protected by controls

Assertion Control

Existence or occurrence Assets or liabilities of the entity exist at a given date and recorded
transactions have occurred during the period.

Completeness All transactions and accounts that should be presented in the financial
statements are included.

Accuracy Transactions and account balances are accurately recorded at the right
amount and in the right period.

Valuation Assets and liabilities are recorded at an appropriate carrying amount in

accordance with accounting policies.

Rights and obligations Assets are the rights of the entity and liabilities are the obligations of
the entity at a given date.

Presentation and disclosure The financial statement components are properly classified, described
and disclosed.
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In accounting for derivatives, it is often useful to ensure there is a specific control covering each
assertion. For each control objective or assertion, the controls must be documented. As part of
this documentation, it is important to specify the attributes of the control regarding its:
• significance—the control will be either a key control or a supplementary control;
• type—there are three types of controls: preventative, detective and corrective
(see further below);
• form—it may be automated (computer-driven), manual or a combination of the two;
• timing—may be event-driven or date-driven; and
• testing—specification of how it will be tested and the evidence retained from testing.

Non-financial reporting risks and controls

Risks and internal controls are not just to protect against misstatements in the financial statements,
although this is a key focus area for accountants. Risks and controls also need to be put in place
to protect more generally against financial risk. To be effective:
• risks and associated control activities must be documented;
• control activities must be allocated to an individual; and
• activities must be subject to regular reporting, with any breaches or controls failures
reported immediately.

Table 8.4 highlights the key financial risks faced, as well as the organisational objectives
in managing those risks.

Table 8.4: Financial risks and objectives

Risk Objective

Liquidity/funding The company has sufficient cash to meet commitments and raise funds
as required

Market risk (e.g. interest, Market risk is managed within board-defined criteria
FX, commodity)

Credit Credit risk is managed within board-defined criteria

Legal Rights and obligations are appropriately protected

Operational Operational risks are clearly understood and controls are in place to
manage such risks

Fraud To protect against rogue trading of derivatives and unauthorised

transactions

Types of internal controls

There are three main types of internal controls and a good control environment will include all
three of them.
1. Detective controls are designed to detect errors or irregularities that may have occurred.
They include reviews of performance, policies and procedures, reconciliations and
verifications. For example, the reconciliation of derivative accounts to bank confirmations
would be a detective control as it detects any differences between the organisation’s internal
records and the bank’s records.
2. Corrective controls are designed to correct errors or irregularities that have been detected.
They include reporting breaches and changing authorisations when roles change.
3. Preventive controls are designed to prevent errors or irregularities from occurring in the first
place. They include policies and procedures, supervision and access controls. For example,
the financial risk management policy would specify the segregation of duties to prevent
individuals from performing functions that would enable them to circumvent controls.
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Regulations
ASX principles on internal control
The ASX Principles, applicable to all listed companies in Australia, were updated in 2014 and
outline expectations for recognising and managing risk, including establishing a sound risk
framework and periodically reviewing the effectiveness of that framework (Principle 7). The
system needs to be able to identify, assess, monitor and manage risk, as well as inform investors
of material changes in the company’s risk profile.

Australian Prudential Regulation Authority (APRA) regulations

The Australian Prudential Regulation Authority (APRA) was established to regulate bodies within
the financial sector and develop the administrative practices and procedures to be applied in
performing that regulatory and administrative role. In doing this, APRA balances the objectives
of financial safety, efficiency and competition.

APRA issues prudential frameworks for each of the four major industries (authorised deposit
taking institutions, general insurance, superannuation funds, life insurance and friendly societies)
that it regulates. The frameworks generally consist of legislation, prudential standards and
guidance notes. As this module is not focused on financial institutions, these regulations have
not been covered.

Australian Securities and Investments Commission (ASIC)

regulations
The Australian Securities and Investments Commission (ASIC) is Australia’s corporate, markets
and financial services regulator. ASIC is required to maintain, facilitate and improve the
performance of the financial system and promote participation and confidence in the system.
ASIC also enforces and gives effect to the law as it applies to financial markets.

ASIC regulates Australian companies, financial markets, financial services organisations and
professionals who deal and advise in investments, superannuation, insurance, deposit taking
and credit. This means that ASIC serves three major roles:

Corporate regulator. ASIC is responsible for ensuring that company directors and officers carry
out their duties honestly, diligently and in the best interests of their companies.

Markets regulator. ASIC assesses how effectively authorised financial markets are complying
with their legal obligations to operate fair, orderly and transparent markets.

Financial services regulator. ASIC licenses and monitors financial services businesses to
ensure that they operate efficiently, honestly and fairly. These businesses typically deal in
superannuation, managed funds, shares and company securities, derivatives, and insurance.

One of the laws that ASIC administers is the licensing of Australian Financial Services Licenses
(AFSLs). The Corporations Act requires people who carry on a business that provides financial
services to hold an AFSL. To qualify for an AFSL the applicant must conform to the regulatory
guides set out by ASIC, including demonstrating competency, training requirements,
compliance systems, dispute resolution capabilities and many other financial requirements.
A number of corporate organisations are subject to an AFSL and this in itself creates a number
of obligations regarding the organisation’s internal control and compliance environment.
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US regulations: Sarbanes–Oxley Act 2002

In response to many recent corporate scandals, in particular Enron, the US Congress enacted
the Sarbanes–Oxley Act 2002 (SOX) to help restore the confidence of investors. SOX established
new rules for auditor independence and corporate responsibility. One visible and challenging
requirement relates to s. 404 of SOX, which requires companies and their auditors to report on
the effectiveness of internal control over financial reporting. SOX is particularly relevant as it
affects most subsidiaries of US companies in Australia as well as Australian entities with securities
listed in the US. As a result of the onerous nature of this requirement, many foreign corporates
have delisted their securities in the US.

Governance framework for financial risk

management
Governance structure
An example of a governance structure for financial risk management is shown in Figure 8.2.
The board is responsible for approving the risk management framework that will lead to
the detailed risk and control matrix used for documenting key risks and associated controls.
These risks and controls then feed into the control self-assessment/compliance system. A key
control over financial risk is a board-approved financial risk management (treasury) policy that
sets all the limits, delegations and approved instruments. These in turn feed into the control
self‑assessment/compliance system. Management and staff sign-off on the various requirements
through a report to the board and a treasury report. Internal audit, where applicable, rotates
through the different functions and reports to the board. External audit will also report its opinion
on the financial statements to the board, together with any significant controls weaknesses
regarding the financial statements.

Figure 8.2: Reporting and review structure

Board

Board audit committee

Risk management
framework CEO

Risk and control matrix

CFO

Treasury policy Treasury and finance staff

Control self-assessment/compliance system

Internal audit

External audit for financial statements

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Financial risk management policy

A key risk management control to consider is the financial risk policy (also known as the treasury
policy). This policy sets the parameters within which management must operate.

Purpose and scope of the policy

The aim of the policy is to provide a statement of the financial risk management policies of the
organisation, based on its risk appetite, strategies and objectives. A financial risk management
operation policy should outline:
• a framework for the management of financial and operational risk (including how the various
risks are measured);
• delegations and authorities;
• authorised instruments to be used for borrowing, investment and risk management;
• performance measures; and
• reporting requirements.

The document should also cover the management of operations associated with financial risk
management activities. The structure of the policy should include operational delegations and
risk parameters designed to ensure flexibility under a broad range of market conditions, and to
provide a framework that can be modified to reflect changes in the organisation’s operations
and objectives.

The policy needs to be updated on a regular basis. Policy changes should be endorsed by
a committee of the board (such as a risk management committee), which should review the
changes and submit them to the board for approval.

Risk appetite
As discussed in Module 1, setting out the risk appetite for the organisation can be difficult.
Further, it may consist of quantitative and qualitative measures. Quantitative measures may
consist of restrictions, such as hedging all foreign exchange exposures over $100 000. In more
complex organisations such as mining companies with natural commodity exposures, the board
might insist that multiple scenarios (with and without hedging) are presented to enable the board
to assess whether the distribution of results is within an acceptable range. The risk appetite may
include qualitative factors (e.g. management will not attempt to profit from speculative activities).

The risk appetite of the board might be specifically stated or indirectly captured via the
restrictions in the policy. Alternatively, it could be a combination of both.

Financial risk management functions

Once the principles of the organisation’s financial risk management objectives are set, they need
to be translated into actions for the organisation’s treasury or risk management function.
Typically, the function’s responsibility would include the following:
• monitoring the organisation’s cash flows and the maturity profile of borrowing facilities to
ensure the group has sufficient funds at all times to maintain its operations;
• arranging and negotiating funding requirements;
• managing the debt portfolio and other financial arrangements;
• monitoring and investing any surplus funds; and
• identifying and managing interest rate, foreign exchange, commodity and counterparty
exposures.
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Board delegation
The financial risk management policy should provide details relating to officers delegated to
undertake financial transactions (investments, borrowings, hedging transactions and remittances)
and execute documents on behalf of the organisation.

Based on the generic structure detailed above, Table 8.5 is an example of a typical delegation
framework of a company. Note that these figures are in AUD millions. They represent the level of
each of the staff positions (e.g. CFO). So, for example, a Treasury manager may have authority
for > 360 day FX transactions up to a limit of AUD 10 million.

Table 8.5: Delegated authorities

Treasurer/ Treasury
CFO Risk manager manager
Authority category (AUD million) (AUD million) (AUD million)

Authority for investments

Deposits with authorised banks up to 180 days 100 60 50
Government securities
• Up to 180-day maturity 100 60 40
• Beyond 180-day maturity 50 20 N/A

Authority for borrowings

New debt facility—board approval required N/A N/A N/A
Existing debt facility
• Up to 180-day maturity 100 60 40
• Beyond 180-day maturity 50 20 N/A

Authority for interest rate transactions

Transactions as part of risk management
committee approved strategies
• Up to 360-day maturity 100 60 40
• Beyond 360-day maturity 50 30 20

Authority for foreign exchange transactions

Transactions as part of risk management
committee approved strategies
• Up to 360-day maturity 50 40 30
• Beyond 360-day maturity 30 20 10

Authority to remit or transfer funds or monies (sign cheques, letters of instruction, EFT or other
commercial means by any of the following two people)

• CEO
• CFO Unlimited
• Secretary

• Group financial controller

50
• Strategic development head

• Treasury manager N/A

Authority to execute standard treasury or banking documentation

• CEO
• CFO
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Authorised instruments and transactions

In addition to setting the delegated authority for the organisation, the board must also, in the
financial risk management policy, approve the use of financial instruments to invest surplus
cash or to facilitate financial risk management. The instruments selected must be specific to
the management of the organisation’s financial exposures. In the event that the organisation
does not have an appetite to use a particular derivative, it should not be included in the list.
In addition, the instruments should only be executed with approved counterparties and within
prescribed limits. The types of instruments that would typically be included in the list are:
• cash investments;
• bank-accepted bills of exchange;
• interest rate swaps;
• interest rate options (normally restricted to hedging only, and excluding sold options);
• spot and forward foreign exchange contracts; and
• currency options (normally restricted to hedging only, and excluding sold options).

➤➤Question 8.1
The list of derivatives above excludes sold options. Why would this be the case?

Performance measurement and benchmarks

Interest rate, foreign exchange and commodity price risk management performance will be
assessed as achievements of stated objectives. As mentioned in Module 1, when setting the
objectives, it is important to ensure they do not encourage the wrong activity. In general terms,
the objectives will be translated into performance benchmarks to assess the ability of the treasury
function to effectively manage financial risks, while not adding to the underlying risk profile of
the business.

Performance in other areas of risk management, such as liquidity (usually measurable), counterparty
risk and operational risk, will have measures that are more qualitative and exception based.
Accordingly, such performance assessment will generally be associated with the extent of
compliance with policies in these areas, and the ability to perform without error in settlements
and other support functions.

Feedback would be provided to the risk management committee in relation to performance

against established strategies and policy guidelines.

Financial risk management policy—key risks and controls

Having formulated the primary responsibilities of the directors and officers of an organisation,
the policy provides a clear statement of general courses of action supporting the overall
objectives and strategies of the company. It is the board’s instruction to management on how
particular aspects of the organisation are to be managed.

The policy should stipulate what the organisation will and will not do and should provide
management with the authority to act. Management can then design procedures to implement
policy and controls to ensure compliance. The policy should also specify the type, content and
frequency of reports to be submitted to the board.
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This section looks at how a company may consider and structure its policy from the following
perspectives:
• liquidity/funding risk management;
• market risk:
–– interest rate risk management;
–– foreign exchange risk management; and
–– commodity price risk management.
• credit/counterparty risk management;
• legal risk management; and
• operational risk management.

In principle, each section should define how each of the above elements is managed within
the organisation.

➤➤Question 8.2
Financial risk functions are constantly exposed to external uncertainties. How can controls be used
to mitigate these risks?

Liquidity/Funding risk management

Definition
Liquidity risk typically results from insufficient cash sources or funding (undrawn facilities) to meet
liabilities when due. Funding risk is the inability to refinance maturing funding or to raise required
debt. Liquidity and funding are inter-related because funding is often the source of liquidity.

An unforeseen event or miscalculation in the required liquidity level will result, in the worst case,
in the inability to meet financial or operational requirements (leading to default and liquidation),
in excessive borrowing costs, or in substantially reduced investment income from an inability to
meet these requirements in an orderly manner.

Most organisations are exposed to liquidity risk on a daily basis (liquidity risk) and in relation to
long-term funding requirements (funding risk). This was discussed in Module 2.

Objectives and management

Liquidity risk management

The objectives of liquidity risk management are to ensure the availability of sufficient funds to
meet daily cash requirements, while also ensuring that cash surpluses in low-interest accounts are
maintained at a minimum level.

These objectives are typically achieved through the following management approach:
• Cash flow forecasting is prepared by the treasury function on a monthly and annual rolling
basis, and updated on a daily basis to recognise changes in the underlying cash flows. In order
for this process to be effective, business units must advise treasury of their cash flows on a
weekly to monthly basis (using a template developed and maintained by the treasury function),
with any significant variation to the original forecast reported being promptly communicated to
treasury on detection.
• A cash buffer is maintained (in the form of undrawn facilities and/or surplus cash) to protect
against sudden unexpected cash requirements.
• Surplus funds are used to repay short-term debt where possible.
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• Sufficient debt facilities are maintained to ensure that adequate funds are available under all
business conditions:
–– using an overdraft facility or standby facility for funding on a short-term basis if required;
and/or
–– using a commercial paper facility for funding of larger amounts if available.
• Minimising the costs associated with transaction banking.

Funding risk management

The objective of funding (also referred to as long-term liquidity) risk management is to ensure
that funding facilities are in place to meet future funding requirements, while avoiding excessive
concentration of funding or the renegotiation of facilities at any point in time.

These objectives are typically achieved through the following management approach:
• maintaining an appropriate credit rating to ensure funds can be raised when required with
an acceptable credit margin—credit ratings depend on many factors, including gearing,
interest cover ratios and the strength of surplus cash flows;
• preparing long-term cash flow forecasts to determine future funding requirements;
• monitoring funding facilities and ensuring there is an adequate buffer in debt covenants;
• diversifying funding sources;
• maintaining strong relationships with financiers; and
• ensuring a spread of funding amounts and maturities as shown in Table 8.6.

Maintaining a strong relationship with financiers is a qualitative function of funding risk

management. It is nevertheless important as it will ensure a stable relationship, optimise
communication and it is more likely to lead to better understanding when times are challenging.
During the GFC, organisations that squeezed financiers on price during the easy credit era
had few friends when times were tough. Just as importantly, a strong relationship helps
in understanding the financier’s credit metrics and limitations on the financier’s funding,
and facilitates discussion of additional requirements well before they are needed.

Having a diverse range of funding sources provides greater flexibility in funding options as
well as potentially lowering the cost of funds. However, this only applies to larger companies,
as smaller companies usually have their main funding sourced from a single provider.

The maturity profile of debt for an organisation should be structured to accommodate the
long‑term nature of assets and the potential for cash flow uncertainty as a result of underlying
business activities and the desire to be able to fund via the capital markets. This is counter-
balanced by the availability and costs of funds, as financiers will limit the term of facilities
(dependent on credit ratings) or charge prohibitive premiums on longer-term facilities.
Accordingly, when seeking funding there is always a compromise between the term desired,
and the availability and cost.

The debt maturity profile table (see Table 8.6) reflects the level of discretion the treasury function
has in setting the maturity profile of the organisation’s debt. In this case, the treasury function has
significant discretion, as it is acceptable to have 40 per cent of debt maturity in the short term.
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Table 8.6: Debt maturity profile

Acceptable range Preferred position

(This is the authorised range (Risk management
Maturity band of the maturity profile of debt) committee approved)

Short term
0–1 year 0–40% 30%

Long term
1–3 years 0–30% 10%
3–5 years 0–50% 20%
5–7 years 0–50% 40%

Credit ratings
An organisation’s credit rating is generally seen as an indication of the organisation’s overall
ability to pay its financial obligations as and when they fall due. It is therefore a primary measure
of the organisation’s likelihood of default. The credit rating assigned to an organisation has
understandable consequences for the organisation’s ability to raise funds (in both debt and
equity markets) and the price at which it is able to raise those funds.

In Australia there are three major credit rating agencies: Standard & Poor’s, Moody’s, and Fitch.
Although each agency has its own methodology for determining credit ratings, each follows a
broadly similar approach.

Generally speaking, the credit rating is assessed in two parts (see Table 8.7 for an example).
The first part involves an evaluation of the business risks faced by the organisation. This will
include country risks, industry characteristics, and the organisation’s competitive position and
profitability relative to peers. While some of the broader macroeconomic factors are outside
the influence of the organisation, its business competitiveness is often a reflection of the
organisation’s risk tolerance and strategy. Risk management is an increasingly important analytical
factor in determining credit ratings.

The second step in the evaluation is the financial risk of the individual organisation. Key financial
indicators generally fall into the following categories: profitability, leverage, cash flow adequacy,
liquidity and financial flexibility. The specific ratios analysed vary by industry and may include profit
margins, return on investment, debt/capital, debt/cash flow, and interest cover ratios. Cash flow
analysis and liquidity assume heightened significance for organisations with speculative-grade
ratings (‘BB+’ and lower). Trends over time and peer comparisons are also evaluated.
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Table 8.7: Example of internal credit rating assessment

Note: The information below is provided for illustrative purposes only. Candidates are not expected to
explain how the various ratings have been derived.

Credit rating
Step 1: Business risk and credit rating calculations

Internal rating Board range Compliance with policy?

Financial risk Aggressive BBB– BBB– to BBB+ OK

Business risk Strong

Financial risk profile

Highly-
Business risk profile

Minimal Modest Intermediate Aggressive leveraged

Excellent AAA AA A BBB BB

Strong AA AA A– BBB– BB–

Satisfactory A BBB+ BBB BB+ B+

Weak BBB BBB– BB+ BB– B

Vulnerable BB B+ B+ B B–

Current credit rating BBB–

Step 2: Financial risk

Inputs

Funds from operations (FFO) ÷ debt 5%

Gearing (%) 54%

Debt/EBITDA 3

Results

Financial risk rating 4

Financial risk rating Aggressive

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Standard & Poor’s ratings were also referred to in Module 2 (Table 2.3) in the context of long-term
debt financing. Similar criteria would be utilised to assess whether the company is operating, and
more importantly is projecting to operate, within the target range that the board is comfortable with.

At all times the organisation should ensure that surplus undrawn debt facilities are available and/
or a predetermined amount of funds is maturing in any one financial year.

Generally, new long-term funding would not be raised without prior approval of the board,
based on recommendations from the risk management committee.

Performance measurement
The liquidity and funding performance should be measured on a monthly basis and reported
to the risk management committee, as shown in Table 8.8.

Table 8.8: Liquidity and funding risk performance measures

Performance measure Benchmark

Liquidity risk management

• Daily bank balance • Surplus cash below a set dollar level at end of day
• Usage of surplus funds • Surplus funds at a margin above the cash
management rate
• Cost of short-term funding • Short-term funding at margin compared to BBSW
((Australian) bank bill swap rates)
• Maintenance of appropriate cash buffer • Maintenance of buffer of specific dollar amount

Funding risk management

• Cost of long-term funding • Long-term funding at a margin compared to
long-term swaps curve
• Maturity profile of debt • Compliance with policy
• Maintain gearing ratio • Within gearing ratio
• Compliance with debt covenants • Strong relationship with financiers

Reporting
The following reports should be provided to the treasury function or risk manager on a weekly basis:
• cash flow and level of cash buffer;
• details of current debt;
• unused funding lines;
• buffer to debt covenants; and
• details of current investments.

In addition, a report should be presented to the risk management committee on a monthly basis
and to the audit committee semi-annually containing the following information:
• cash flow and level of cash buffer;
• details of current debt, including a comparison to forecast debt level;
• details of current investments;
• short- and long-term cost of funds compared to a benchmark (e.g. BBSW or Commonwealth
Government Securities (CGS));
• refinancing risk profile compared to policy;
• any breaches of the policy; and
• savings in transactional banking arrangements.
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➤➤Question 8.3
Your review of the treasury function’s operational risks has identified that the function’s highest
ranked risk was liquidity risk. The head of the treasury function wants the company’s liquidity policy
to be revised and has assigned the task to you. Before you begin the assignment, you arrange to
discuss the brief with the head of the treasury function. What would be some of the questions
and issues you might want to discuss with the head of the treasury function before starting
the assignment?

Market risk management

Market risk is the risk of loss due to adverse changes in the market value (the price) of an
instrument, transaction, exposure or portfolio of instruments. Such exposure occurs with respect
to derivative instruments when there are changes in market factors—such as underlying interest
rates, exchange rates, equity prices and commodity prices—or in the volatility of these factors.

Most organisations have a natural exposure to one or more of the following risks:
• commodity price risk;
• foreign currency risk; and
• interest rate risk.

Hence, a financial risk management policy should explain:

• how to measure the exposure;
• the board’s approach to managing the exposures;
• measures to manage the exposures, including a list of authorised derivatives;
• who can execute transactions;
• the time horizon to manage the exposures; and
• the limits associated with the exposures.

Interest rate risk management

Definition
Interest rate risk, as discussed in Module 5, is the risk that movements in interest rates will affect
financial performance by increasing interest expenses or reducing interest income. Changes in
market rates of interest may also affect the value of fixed-rate securities (e.g. as interest rates
increase, their value falls).

Ideally, the board would use sensitivity analysis to predict the effect on profit and loss (P&L) of
a given change in interest rates over a suitable length of time. The board must also consider
the effect of the discount factor used to give present-day valuations—and its indirect effects on,
for example, economic growth and balance sheet growth.

Given that the majority of assets held by most organisations are non-financial in nature, interest
rate risk arises primarily from financial liabilities. Therefore, such an organisation may define its
interest rate risk as the potential for movements in interest rates to result in significantly higher
net interest costs.

Objectives and management

Interest rate risk may be mitigated by including a mix of fixed- and floating-rate debt with a range
of maturities in the liability portfolio, and ensuring that new or replacement debt is added in a
way that minimises any concentration of maturities or repricing dates.
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Organisations are exposed to interest rate risk when they have borrowed on a floating-rate basis.
The objective of interest rate risk management is therefore to minimise the impact of rising
interest rates on net interest costs.

Accordingly, interest costs are generally managed by hedging a portion of debt in accordance
with the parameters approved by the board (see ‘Hedging guidelines’ below). For the purposes
of this policy, hedging may be defined as:
• fixing the interest cost of debt at a predetermined level; and/or
• placing a maximum rate above which interest costs cannot be permitted to rise; and/or
• specifying the maximum amount of debt that may be subject to interest rate movements.

Normally the CFO is responsible for determining the level and term of hedging in conjunction
with the treasury function or risk manager within the confines of the board-approved policy.
The treasury function is then responsible for implementing approved strategies to achieve
agreed hedging ranges.

In determining the appropriate hedging level, the following factors should be considered:
• the sensitivity of the organisation’s cash flows to movements in interest rates; and
• the prevailing and expected interest rate environment.

Hedging guidelines
For an organisation to determine an appropriate hedging guideline, a detailed sensitivity analysis
should be completed based on the organisation’s actual and expected financial liabilities.
Once the sensitivity has been completed, the results of the analysis may be presented in the
policy. For example, the total debt of an organisation (current and budgeted) might be hedged in
accordance with the guidelines in Table 8.9. Normally, the target range is determined by annual
board approval of the strategic treasury plan and it would be expected that a range close to the
target be achieved. Significant changes from the target would require further communication to
the board.

Table 8.9: Interest rate risk management

Budget period Hedging target % Acceptable range %

0–6 months 50% 0–80%

7–12 months 40% 0–80%
1–2 years 25% 0–50%
2–3 years 20% 0–30%
3–5 years 10% 0–20%

Performance measurement
Performance in relation to interest rate risk management is normally measured on a monthly
basis (see Table 8.10 for an example).

Table 8.10: Interest rate performance measures

Performance measure Benchmark

• Weighted average cost of borrowings • Neutral passive benchmark

(interest expense / total borrowings)
• Net interest cost • Budget
• Interest rate profile of debt • Compliance with board-approved profile
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Reporting
A report should be provided on a monthly basis to the treasury function or risk manager and
the risk management committee containing the following information:
• weighted average cost of funds compared to the benchmark for the current and previous
month/quarter;
• year-to-date net interest costs compared to the budget;
• hedging profile of debt; and
• sensitivity of net interest costs after hedging for movements in the interest rate.

Foreign exchange risk management

Definition
Foreign exchange (FX) risk, as defined in Module 1 and 6, describes the risk of variation in the
rate of exchange used to convert foreign currency revenues, expenses, assets and liabilities to
the firm’s functional currency. There are three main types of foreign exchange exposures:
1. Transaction exposures from normal operational business activities.
2. Translation exposure from converting long-term assets/liabilities.
3. Competitive or economic exposures from adopting a different approach to competitors.

Objectives and management

The main objective of foreign exchange risk management is to manage the impact of foreign
exchange exposures in order to maintain exposure to foreign currencies at an acceptable
level and to minimise the impact of adverse movements in exchange rates relevant to the
organisation.

• Foreign exchange risk management starts with the business units, which may:
(i) identify opportunities for locking in margins when they buy or sell in foreign currencies
by locking in their costs or revenues by immediately hedging such exposures; or
(ii) identify other opportunities where they wish to insure against achieving less than a
benchmark profit (or cost), in which case options (a form of insurance) may be preferable.

• Foreign exchange management always needs to be undertaken in the context of the

underlying business, as is done with other business pricing decisions. This is based on
the simple economic equation:

Cost / Revenue = Price × Quantity

But in the cases where global markets are involved:

Cost / Revenue = Currency Price (goods) × Price (exchange rate) × Quantity

Where a company is exposed to translation risk, it is able to create a natural hedge by borrowing
in the currency of its foreign currency assets so that changes in value may directly offset each
other. This is particularly relevant to translation exposure, which is the conversion of assets and
liabilities in foreign currencies to the functional currency of the balance sheet.

For the purpose of setting policy limits, hedging may be defined as fixing the exchange rate in
respect of foreign currency payments or receipts at a predetermined level or placing a maximum
(or minimum) exchange rate above (or below) which exchange rates cannot rise (or fall).
In addition, there may be limits placed on the amount of exposure the organisation will bear
from translation risk on specific investments.
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The CFO is often responsible for determining the level and term of hedging in conjunction with
the treasury function or risk manager, who is then responsible for implementing strategies to
achieve the agreed hedging level.

In determining the appropriate hedging level, the following factors should be considered:
• the sensitivity of the organisation’s cash flows, profit margins or costs to movements in foreign
exchange rates;
• the degree of certainty over projected foreign exchange payments and receipts that are to
be hedged; and
• the prevailing and expected exchange rate environment.

If the foreign exchange exposure is created via forecast commodity sales, consideration
could also be given to any correlation between the commodity price and the exchange rate,
although any correlation may only be short-term.

Hedging guidelines
Once again, in order for the organisation to determine an appropriate hedging guideline,
a detailed sensitivity analysis of its foreign exchange exposure must be completed. Once the
sensitivity has been completed, the results of the analysis may be presented in the policy.

For example, the foreign exchange exposure of the organisation arises in relation to committed
exposures and highly probable forecast exposures and could be hedged in accordance with the
guidelines in Table 8.11.

Table 8.11: Foreign exchange exposure limits

Budget period Hedging target % Acceptable range %

Committed exposures
0–6 months 100% 80–100%
7–12 months 70% 50–100%

Highly probable forecast exposures

0–6 months 50% 30–70%
7–12 months 30% 20–50%

The longer the term, the lower the acceptable range—this reflects the greater uncertainty
of exposures further into the future. The board would approve the target hedging range as
part of the annual strategic treasury plan. Targets would be expected to be maintained, with
communication back to the board if the target range is to be changed significantly. In addition,
the board’s approval must be obtained before moving beyond the acceptable range permitted
by the policy.

Performance measurement
Performance in relation to the management of foreign exchange risk is normally measured on
a monthly basis. An example is shown in Table 8.12.
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Table 8.12: Foreign exchange performance measures

Performance measure Benchmark

• Foreign exchange hedging profile • Compliance with board-approved profile

• Foreign exchange gains and losses • Budget—as set by the business groups/neutral benchmark
• Foreign exchange rate achieved on • Budget—as set by the business groups/neutral benchmark
purchases and sales

Reporting
A foreign exchange exposure report should be provided to the treasury or risk manager on
a weekly basis and should include the following information:
• Committed and expected foreign exchange receipts and payments in each currency for
the forthcoming 12 months.
• The total face value of authorised instruments that have been taken out to hedge the
monthly exposure.
• The percentage of exposure hedged in each month for each currency.
• A list of all outstanding foreign exchange hedging contracts, including details of contracts
opened and closed during the week.
• A sensitivity analysis showing the impact of a designated movement in the AUD exchange
rate against each currency on the monthly unhedged exposure.

On a monthly basis, a summary report should be prepared for the risk management committee,
including the following information:
• Monthly foreign exchange exposure in each currency for the forthcoming 12 months.
• The total face value of authorised instruments that have been taken out to hedge the
monthly exposures.
• The percentage of exposures hedged in each month for each currency compared to policy
guidelines.
• A sensitivity analysis showing the impact of a designated movement in the exchange rate
against each currency on the monthly unhedged exposure.

Table 8.13 represents a report format that may be used by a large corporation.

Table 8.13 reflects the organisation’s exposure to the USD as a result of its forecast transactions.
Normally, such a table will show the exposure for the next 12 months, then 1–2 years, 2–3 years
etc., depending on the hedge policy of the organisation. Against the exposure in the first month,
the organisation has noted the cover that is in place in the form of USD cash balances at bank,
forward exchange contracts and options. Options and non-options are split as they provide
different types of protection. This is then compared to the policy limits set by the organisation
to determine whether these ratios are within policy guidelines. Such a report provides a quick
snapshot of the currency position to management at a particular point in time.
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Table 8.13: Foreign exchange management—USD exposures

1st quarter 2nd quarter 3rd quarter 4th quarter

Hedge details USD millions USD millions USD millions USD millions

Committed purchases USD 120 110 100 130

Hedge cover

Cash USD

FEC 120 110 70 91

Options

Total cover 120 110 70 91

Per cent hedged 100% 100% 70% 70%

Average rate achieved 0.88 0.91 0.90 0.89

Within policy guidelines? Yes

Commodity price risk management

Definition
Commodity price risk, as defined in Module 6, is the risk that a change in the price of a
commodity that is a key input or output of a business will adversely affect financial performance.
It should be noted that many commodities, such as oil, gold and many agricultural products,
are usually denominated and traded globally in USDs. Hence, an Australian organisation that
produces oil will be exposed to both the price of the commodity and the exchange rate between
USDs and AUDs.

Objectives and management

The objectives and management of commodity risk are almost the same as foreign exchange
risk, and accordingly, have not been replicated here. However, an additional factor to consider
in commodity price hedging is the interplay between exchange rates and commodity prices.
History has shown that, as commodity prices rise, the value of the Australian dollar also rises.
Put simply, as demand for commodities increases, the demand for AUD needed to buy them
increases, thereby driving up the AUD’s value compared to other currencies.

Since the AUD is considered in world markets to be influenced by commodity prices, it is

possible that when the commodity price is increasing the AUD will also be increasing and vice
versa. Hence, the correlation between the AUD and the commodity being hedged in USDs
should influence the hedging policy of the organisation. However, the correlation between
currency and commodities is not stable. It can vary significantly over certain periods and is not
specific to any one commodity. The Pasminco case study is a good example of the consequences
of ignoring the risks of this correlation.

Credit/counterparty risk management

Definition
Credit or counterparty risk is the risk that a counterparty to a financial transaction will default on its
obligations to an organisation. The general terms associated with ‘counterparty risk’ may include:
• Credit risk. The risk that another party in a transaction will not be able to meet its financial
obligations.
• Country/political/sovereign risk. Associated with government directives and policies
that may affect the contractual performance of either party to the transaction, and that are
generally beyond the direct control of the counterparty.
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• Settlement or delivery risk. May exist if there is a default in a settlement or delivery, in which
case all other exposures or positions with that counterparty may need to be terminated,
thus establishing claims for transaction costs.

Objectives and management

The objective of counterparty risk management is to minimise the potential for losses arising from
one or more counterparties to a financial transaction defaulting on their obligations to the entity.

This is achieved by:

• transacting only with approved counterparties and within set limits;
• selecting approved counterparties on the basis of minimum credit ratings criteria;
• setting a cap on the exposure to a counterparty based on their credit rating; and
• diversifying the number of approved counterparties where possible.

Dealing with creditworthy counterparties and limiting the total amount of credit risk taken for
all counterparties will mitigate credit risk. The organisation can conduct its own evaluation of
counterparties/creditors but it is more common to refer to independent credit evaluation services.

The exposure to individual counterparties is the aggregation of the calculated exposures of

each investment and hedging transaction entered into with that counterparty. An example of
a method in which an organisation may base its calculation to determine counterparty exposure
is detailed in Table 8.14. It should be noted that, in Table 8.14, the credit limit for derivatives is
based on the instruments’ ‘potential credit exposure’ (i.e. what the derivatives’ values could be
over their life). The potential credit exposure should be considered as many derivatives have a
fair value of zero at inception but this can change dramatically. Treasury systems may facilitate
more sophisticated methods of computation of potential credit exposure.

Table 8.14: Calculation of credit exposures

Instruments Period Calculation base/Exposure

Cash investment Cash Principal amount

Money market securities Face value of the security

Interest rate Swaps with a settlement date Notional principal of the swap
swaps (IRS) less than or equal to one year × 5% × days of maturity/365

Swaps with a settlement date An incremental increase of 5% per year

greater than one year (therefore, for a 2½ year swap, the exposure
would be a notional amount of the swap ×
12.5%)

Currency swaps/ Swaps/FECs with a settlement date Notional principal of the swap/FEC × 15% ×
forward exchange less than or equal to one year days of maturity/days per year
contracts
Swaps/FECs with a settlement date An incremental increase of 5% per year
greater than one year (e.g. for a swap/FEC with a maturity date of
three years, the exposure would be notional
principal of the swap/FEC × 25% (i.e. 15% +
5% + 5%))

Table 8.14 provides calculations for the potential credit exposure on derivatives. This is an
approximation of the maximum positive market value that the derivative may have over its term.
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In the interest rate swaps row, assume a notional principal of $1 million. Assume also that the
swap is due for settlement in 180 days (less than one year). The exposure is calculated as:
$1 million × 5% × 180 / 365 = $24 658. This is the potential credit exposure the organisation
may have to the IRS. The organisation can then compare this exposure to its credit limit for a
particular counterparty or for a particular type of instrument to monitor the risk or exposure
that it has.

In the currency swaps/forward exchange contracts row, assume a notional principal of $2 million.
Also assume a forward exchange contract of 4 years’ maturity. The calculation base is 30 per
cent, being 15 per cent for the first year and then an incremental increase of 5 per cent per
year (i.e. 15% + 5% + 5% + 5%). The exposure is therefore $600 000 (i.e. $2 million x 30%).
The organisation can then compare this exposure to its credit limit for a particular counterparty
or for a particular type of instrument to monitor the risk or exposure it has.

➤➤Question 8.4
List the primary objectives of a credit policy.

Legal and regulatory risk management

Definition
Legal risk is the risk of not being able to enforce contracts or agreements. It arises for a variety
of reasons. For example, a counterparty might lack the legal or regulatory authority to engage in
a transaction. Legal risks usually only become apparent when a counterparty loses money on a
transaction and decides to sue the other party to avoid meeting its obligations, or defaults on its
obligations. For example, a NSW-owned electricity generator sought to declare void a number
of electricity derivatives (after it incurred losses of tens of millions of dollars) on the basis that the
generator’s trader did not have authority to execute the transactions. Accordingly, organisations
must have in place strong controls over legal documentation to ensure that they are not exposed
to potential loss in the event that the counterparty disputes their documentation.

The principal legal agreement that governs most hedging transactions is the International Swaps
and Derivatives Association (ISDA) agreement. ISDA documentation should be mandatory
for all derivative transactions and should be signed by all counterparties. By signing an ISDA
agreement, organisations have a basis for understanding the legal status of their financial
transactions with the counterparty in the event that there is a dispute. It also simplifies the
process at the time of execution of transactions, as the transaction confirmation can be limited
to the description of the transaction (rather than full details of the legal conditions of the
transaction, which have been pre-agreed in the ISDA agreement).

Any variations to standard ISDA documentation, including the adoption of new products,
should be explicitly approved by appropriate legal personnel. Internal and external parties
(i.e. employees or agents of counterparties) authorised to confirm ISDA transactions should be
specifically identified.

Occasionally, transactions may be executed that are not covered by an ISDA agreement. In this
situation, legal advice should be sought as to the appropriateness and legal standing of the
agreement in the event of a dispute.
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Regulatory requirements
Many organisations are subject to regulatory compliance. For example, CEOs and CFOs of
ASX‑listed companies in Australia must sign a statement to the effect that they have appropriate
risk management frameworks and effective internal controls in place. To support such statements,
the companies must have documented the risk management framework and internal control
environment for the treasury operation. This is commonly evidenced by a financial risk management
policy supported by a self-assessment questionnaire and reports from internal auditors.

Other organisations may also be subject to special regulatory controls by ASIC or APRA.
For example, all banks are subject to special controls by APRA. Electricity company treasury
functions are frequently required to be licensed by ASIC, and fund management companies that
look after superannuation funds must comply with specific ASIC regulations.

Where organisations are subject to specific regulation, those regulatory requirements should be
documented in the policy in the same way as other board requirements. Likewise, there should
be a monitoring process to ensure that the regulations are complied with by the organisation.

Another aspect of regulatory risk is the potential impact of a change in tax law. For example,
when the British Government changed the tax code to remove a particular tax benefit during the
summer of 1997, one major investment bank suffered huge losses. As a result, if organisations are
exposed to the risk of tax changes, they would normally seek an indemnity from the counterparty
to the transaction.

Objectives and management

The objective of managing legal risk is to ensure that the organisation complies with its legal
requirements and can demonstrate compliance when necessary. This risk can be managed by
the following methods:
• documenting the policy risks and regulatory requirements involved;
• stipulating a legal process to approve legal documents—such as approving the ISDA
agreement with the counterparty prior to executing any transactions;
• reviewing any non-standard agreements by legal experts;
• factoring into the agreement any change in the regulatory environment where this could
substantially affect the profitability of transactions; and
• maintaining a checklist to verify compliance with regulatory requirements.

Scope and content of board reports

The key purpose of financial risk management reports to the board is to enable directors to
understand the organisation’s exposure to financial risk, the effectiveness of risk management,
and the likely effect of exposures on the organisation’s financial performance.

While no universally applicable standards for form and content of these reports to the board
exist, a set of common issues can be identified. The manner and extent of reporting will depend
on the size of the organisation, its structure, the nature of its operations, and the size and type
of financial risks to be managed. Board reports should reflect policy requirements, available
resources and operating structure. In all organisations, reports should be broken down by type
of risk management activity. They should address accountability and identify actual performance
against the relevant benchmark and policy guidelines.
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As previously identified, the main items relating to financial risks include:

• liquidity and funding position;
• interest rate exposure;
• currency exposures;
• commodity exposures;
• sensitivity analysis with respect to commodity prices or exchange rates;
• credit or counterparty exposures;
• financial structure;
• market conditions;
• compliance with approved policies and procedures; and
• the effect of financial instrument transactions on the organisation’s financial performance.

Reports normally include a description of conditions in the financial markets over the period
and market comparisons with previous periods, and highlight any potential influence on the
organisation’s performance that may require adjustments to policy. For each exposure identified
and measured, the report would normally include the following:
• the current level and nature of hedged and unhedged exposures; and
• a sensitivity analysis that shows the effect on underlying risk of movements in interest
rates/commodity prices. This could be done as an assessment of the effect of prospective
movements on profit and loss, or on a mark-to-market basis.

Information relating to specific risk categories that might be included in the board report is
detailed in the following discussion as a guide. It is important that the board report provides
the board and management with adequate information to understand the financial risks of
the organisation and how they have been managed, as well as highlight any areas that need
further attention.

The summary report shown in Figure 8.3 covers all the key areas using a warnings approach
(three ratings being: OK, Warning!, Breach) to identify any areas needing further attention.
As can be seen there are some warnings against liquidity and capital as a result of a recent share
buy-back as described by the treasurer. The treasurer also explains that this will be corrected
in the following month. Instead of a warnings approach, companies often use a traffic-light
approach. The report also provides a Tornado chart that indicates the impact on the profitability
of the company over various market risks, with a 95 per cent confidence level. This provides
directors with information on the potential impact of their unhedged positions and would help
them assess whether, given the stress results, they are comfortable with the current positions for
the reporting period.

This could alternatively have been disclosed by simply stress-testing the P&L for various market
risk inputs or by highlighting the level of ‘Earnings at risk’ for the various market risk factors.
‘Earnings at risk’ is similar to the information in the Tornado chart and indicates, for a given
confidence factor, the level of losses that could be incurred.
MODULE 8
 Treasury reporting For period ending 30 June 20X4
Treasurer comments Performance Compliance

Liquidity has been negatively impacted

Board policy Warning!
Amber
by recent buy back. Will be back to
normal next month. Likewise, capital KPI OK
buffer will be back within acceptable
levels next month. Bank covenants OK

Performance Performance Risk management

P&L (Net income) Facilities 206.60 million Foreign exchange

– Original budget 196.00 million Utilisation 66% 78.00% OK
– Estimate (Forecast) 148.22 million 80.00%
– On target? No Maturity profile Commodity
$million 75.00% OK
Tornado chart (Effect on net income) 600
80.00%
explain how the various ratings have been derived.

– Range 95% confidence ±150 million 500 Interest

– Worst case –208 million 400 50.00% OK
–100 – 100 200 300 50.00%
Variability –200
$million
Credit risk
200
55.00% OK
Commodity 100
57.00%
Liquidity buffer
<1 1–2 2–3 3–4 4–5 5+
FX Year 29.00% Warning!
40.00%
Capital buffer
Banking commentary
Interest 30.00% Warning!
Funding has been arranged for 44.00%
Interest FX Commodity debt maturing in the next 6 months. Target credit rating
Figure 8.3: Example of a treasury report summary at 30 June 20X4

Worst –3 –55 –150

3 55 150 55.00% OK
Best
55.00%

OK Above target Benchmark

Warning! Within 10% of target Actual position
Breach Outside target by over 10%
Note: The information below is provided for illustrative purposes only. Candidates are not expected to

I, John Smith, treasurer of ABC, certify that to the best of my knowledge this summary report and the attached details are accurate.
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Reporting on the financial structure

Financial structure reporting could include the following:
• Current balances of issued capital, capital reserves, revenue reserves, subordinated debt,
current borrowings, long-term borrowings and unused committed facilities and forecast
movements.
• Costs incurred in serving the financial structure, including dividends and interest.
• Financial ratios and percentages that measure the status and condition of the financial
gearing, interest cover and debt maturity (e.g. capital gearing, interest cover, cost of capital,
standby credit and debt maturity profile).
• Compliance with financial covenants and undertakings, and a forecast for the current year
(provides early warning).
• Capacity to leverage and still remain in compliance with covenants.
• Sensitivity of gearing to credit ratings (ability to grow).

Table 8.15 represents an example of a table that may be included in a board presentation.

There is no standard reporting format for this type of report to management. The appropriate
report is one that provides management with sufficient information to manage the risks.
The information in Table 8.15 has been set out to show:
• the cost of current debt facilities;
• the maturity profile of the debt and whether this is within board limits;
• the fixed versus floating profile of the debt and whether this is within board limits; and
• the computation of the asset-to-debt ratio or gearing ratio of the organisation to determine
whether the gearing is within board limits.
MODULE 8
 Debt facilities AUD millions Debt analysis
Type Actual % Spread above* Month end Maturity
Bank debt term 1 000
General facility Floating 4.36% 0.45% 1 000 June 20X4
Average debt maturity 5.49 years
Bank overdraft 8.68% 19
Overdraft Australia Fixed 12.00% 8.50% 0 June 20X4 Maturity within limits? Yes
Overdraft US Both 8.68% 5.67% 19 June 20X4

Fixed Current 20X4 20X5

Capital market debt 5.21% 950 year
US Bond 1 Floating 4.28% 0.48% 100 May 20X3 Fixed 38% 26% 26%
US Bond 2 Fixed 1.74% 0.38% 100 September 20X4 Interest rate profile within policy
US Bond 3 Fixed 6.25% 0.78% 100 December 20X5 limits? Yes

US Bond 4 Fixed 7.17% 1.47% 100 May 20X6

US CP Fixed 7.50% 3.45% 200 June 20X7
Australia— Floating 4.10% 0.96% 200 August 20X8
Medium-term note
Australia CP Floating 4.57% 0.78% 150 Rolling 1 year Debt covenants/target credit rating
Total portfolio Weighted 4.81% 1 969 Liabilities/Total assets
average (within limits—Yes)
Current 20X4 20X5
year
Table 8.15: Example of a debt portfolio summary at 30 June 20X4

Unused facilities 200 Rolling 1 year Ratio 38% 35% 29%

* Indicates the cost above the bank bill swap rate. The table indicates that the overdraft facilities are very expensive and use of them should be minimised.
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Covenants checker
Number of covenant breaches (exc. ratios) 0
Ratios based covenants—Number of breaches 0
Number of threshold breaches 0
Overall state OK
| CONTROLLING RISKS

Covenants listing
Deal/ Type of
Ref Contract ID Counterparty Notional deal Covenant? Ref Sub-type Description Met? State
1 1A Other Maintain property and general liability Yes 1
insurance
1B Other Quarterly or monthly financial statement Yes 1
submission to the bank
1C Other No sale of equipment without Yes 1
prior lender approval
Floating
1982333FFA XYZ 20 000 000 Yes 1D Other No changes in management or merger Yes 1
rate loan
explain how the various ratings have been derived.

without lender’s permission

1E Other No further loans from other sources to Yes 1
company without lender approval
Table 8.16: Example of covenant compliance

1F Liquidity Ratio Maintain Current Ratio greater than 1 Yes 1

of a covenant compliance report is provided in Table 8.16.

1G Liquidity Ratio Maintain Quick Ratio greater than 1 Yes 1

1H Liquidity Ratio Maintain Times Interest Earned greater than 3 Yes 1

Covenants checker
Breach covenant 0
Breach threshold 0
Overall state OK

Covenants—ratios testing
Current Forecast
Covenant Type Description Greater Less than Threshold Ratio type 20X4 20X5
ref than
1F Liquidity Ratio Maintain Current Ratio greater than 1 1 N/A 5% Current Ratio OK OK
Note: The information below is provided for illustrative purposes only. Candidates are not expected to
Given the importance of complying with debt covenants, a process of monitoring and reporting

1G Liquidity Ratio Maintain Quick Ratio greater than 1 1 N/A 5% Quick Ratio OK OK
1H Liquidity Ratio Maintain Times Interest Earned greater than 3 3 N/A 5% Times Interest
needs to be put in place to assess current compliance as well as projected compliance. An example

OK OK
Earned
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Market condition reporting

Market condition reporting could include a description highlighting financial market conditions
that may affect the organisation’s performance and influence future strategy.

Compliance reporting
Compliance reporting could include:
• certification that all policies have been adhered to;
• instances where stated policies may have been breached;
• reasons for the breaches and what actions, if any, have been taken to rectify the situations; and
• a summary of deals outstanding or unconfirmed or that are in excess of total limits.

Financial results of financial instrument transactions

Financial results could include:
• realised gains and losses for each risk area based on figures supplied from the general ledger
by staff independent of those executing the derivative transactions; and
• unrealised gains and losses on all forward and off-balance-sheet transactions identified for
each risk area—wherever possible, the result should be based on independent valuations
made by independent accounting staff and should reflect:
–– independence of data (process rates etc.);
–– consistency of data (same source); and
–– the integrity and accuracy of the valuation model.

Need for procedures

Procedures are the operating steps and actions that must be taken to implement the requirements
of the organisation’s policies. An appropriate set of procedures will do the following:
• Provide a consistent guide for staff to carry out their duties. Specific procedures protect
against misunderstandings and prevent shortcuts that could lead to unintended risks.
They also facilitate continuity if there is a change of personnel.
• Set out the structure of decision-making and related authorities. It must be clear where the
authority lies to manage financial risks. In large organisations, financial risk management
decisions may be made centrally in a treasury function, or in individual divisions or
subsidiaries. Different types of decisions may require the approval of different levels of
management. Such matters should be explained in the general policies, as well as in the
detailed procedures.
• Specify the internal controls necessary for effective management of the activity. The proper
conduct of appropriate internal controls is fundamental to good corporate governance, and
their absence should be a sign to directors that activities are not appropriately managed.
• Provide protection against fraud and error. Because of the often large amounts of money
involved, policies and procedures must incorporate processes for verification and supervision.
• Ensure that the board works with both internal and external auditors to be assured that
policies and procedures are adhered to.
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Operational risks
Operational risk—definition and objectives
Operational risks are risks arising from the general operations of an organisation’s financial risk
management function (commonly referred to as the treasury function). Operational risks include:
• fraud and theft;
• unauthorised use of financial instruments and other breaches of delegated authority; and
• failure to settle financial transactions accurately and in a timely manner.

To minimise operational risk in relation to financial risk management activities, the objectives
of the organisation are to:
• keep proper accounts and records of the transactions and affairs of the organisation;
• maintain an internal control framework that minimises potential losses arising from
unrecorded or unauthorised transactions, or from errors in transaction settlement;
• place priority on the retention or recruitment of high-quality staff;
• ensure the availability and reliability of hardware and software systems at all times; and
• maintain the financial risk management policy.

In accordance with the risk and control matrix process, clear controls should be in place for
each risk identified, as well as a compliance/assurance system to ensure key controls are
operating effectively.

The fiduciary obligations of directors require them to review regular reports on compliance,
for example:
• periodic confirmation from senior management that, except for breaches noted, operations
have been conducted in accordance with policies approved by the board;
• periodic internal audit reports providing assurance that key controls are in place and
operating effectively;
• confirmation from management that all known departures from authorised policies have
been reported to the board or a board subcommittee (e.g. the risk management committee),
and providing details of any breaches of policy such as:
–– the date and circumstance of the occurrence;
–– explanations of how the breach occurred (e.g. system failure, oversight, lack of training or
wilful disregard);
–– consequences of the event, including any effect on profit or loss (the circumstances
should be investigated even if profit resulted from the non-compliance);
–– remedial action taken or proposed; and
–– any follow-up action required.

Staff must be encouraged to make voluntary disclosure of any compliance breach. This is unlikely
to happen if the entity’s culture is to overreact to minor mistakes or losses. In this environment,
staff attempt to bury mistakes. Typically, it is the responsibility of the middle office to independently
monitor and report on such occurrences as they arise. The notion of the middle office will be
explained in the next section.

Performance in relation to the management of operational risk should be measured on a monthly

basis as shown in Table 8.17.

Table 8.17: Operational risk performance measures

Performance measure Benchmark

Breaches of policy Nil

Audit issues Nil
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Australian firms have found that they have to revise their policies and procedures at least every
two years and often annually due to continually changing legislation and standards. In some
organisations, this is a continuous process that limits the time between formal reviews of all policies
and procedures. The next review date should be stated in the policy to ensure its regular review.

Segregation of duties
An effective operational control environment requires the segregation of duties. Adequate
segregation of duties should be maintained to minimise the risk of fraud. Transaction settlements,
confirmations, reconciliation and accounting should be undertaken by staff independent of the
person who transacts the deal. To ensure independence of functional trading activities, companies
with major trading exposures would normally establish a three-office organisational structure.
This structure ensures appropriate checks and balances and the maintenance of data integrity,
security, and accountability. In a typical organisation, this is referred to as the segregation of the
front, middle and back offices.

The importance of this segregation should not be underestimated. Derivatives can create a
significant exposure to a corporation instantaneously via a phone call to the company’s bank.
Once the front office staff have initiated the transaction—normally via a deal sheet—this should
be passed to the back office, with the front office having no further access to the recording or
editing of the transaction. The back office will verify the transaction to a third-party confirmation
to ensure that the transaction is valid, captured promptly and accurately in the accounting
systems, and is legally binding.

Two fatal faults in the National Australia Bank (NAB) options disaster were that:
1. all transactions were not confirmed by third-party confirmations; and
2. traders were able to modify existing transactions in the system subsequent to initiation
of the transactions.

Both of these activities by the front office in the NAB enabled the front office to hide the
true positions.

The back office should also perform the accounting and settlements. The middle office is
typically responsible for independently measuring the exposures, valuing derivatives and
monitoring exposures against limits in accordance with board policy to ensure that the front
office is complying with board policy.

The responsibilities of each of part of the three-office organisation structure may be summarised
as follows:

Front office. The front office executes the company’s risk-taking and risk-mitigating strategies.
The front office’s functions include deal execution—buying, selling and hedging of physical
commodities or financial instruments. The front office is responsible for initially capturing and
logging a transaction’s specific terms and conditions.

Middle office. The middle office is responsible for maintaining the overall control environment
and assessing compliance with the risk management policy. The middle office provides a
significant level of control and policing of the front office’s activities and should therefore be
independent of the front office, reporting to the CFO. The middle office’s functions include
assuring data integrity through deal validation and monitoring exposures against policy. In some
organisations, the middle office may also perform the role of corporate risk management and/or
the credit function.
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Back office. The back office functions include processes in support of the front office, such as
deal confirmation, settlement, accounting, invoicing, dispute resolution, tax reporting, financial
reporting and contract administration. Key functions and requirements of the back office include
the following:

• Experienced personnel. One of the recurring themes in derivative disasters is the situation
where the back office simply does not understand the transactions that the front office has
executed; that is, the back office is purely a bookkeeping (recording) function. It is critical
that the middle and back office understand the transactions executed by the front office in
the context of the organisation’s policy. Directors likewise need to understand the nature of
derivatives used by the organisation before they authorise their use.

• Authorisations. All transactions must be duly authorised in accordance with approved

delegation of authority as amended from time to time by the board. In the case of the treasury
function, there is normally a treasury policy or charter that the board approves which details:
–– who has been delegated authority for different limits;
–– the degree of discretion, if any, different levels of management have in respect of the
policy; and
–– a list of authorised derivative instruments and counterparties.

This is also discussed in Appendix 8.1.

Process and system risk

Systems and processes should be commensurate with the complexity of the operations,
such that exposures and positions can be accurately captured and aligned with policy settings.
Accordingly, new derivatives should not be approved until all parts of the organisation are
satisfied that they can appropriately measure and record the new instruments.

• Reporting of compliance with limits, breaches and performance. Reporting of exposures

against limits and performance against benchmarks is to be complete, accurate and in
accordance with predetermined timing guidelines. This should be done independently of
the front office and, as mentioned above, is normally the role of the middle office. In the
absence of a middle office, this would be performed by the back office.

• Timeliness. Transaction entry, processing and reconciliation should be performed on a timely

basis. Given the size of exposures that derivatives can create instantaneously, it is critical that
treasury exposures and derivative transactions are captured promptly and accurately. This is
normally achieved via key performance indicators (KPIs) on the accuracy of exposures and via
the timeliness and accuracy of the confirmation process.

• Register of transactions. The Corporations Act 2001 (Cwlth) requires that all companies
in Australia maintain appropriate records. A comprehensive register of all derivative
transactions should be maintained by a company. This is especially important as derivatives
frequently have no value at inception. For most companies, the register will take the form
of a computerised record in a treasury system; hence, the importance of treasury systems.
The register of transactions is an excellent way to maintain a clean data trail of the derivative
transactions from inception to settlement. Treasury systems can also be used to segregate
duties and control access to functions via passwords, while at the same time permitting
access by all relevant parties (front, middle and back office) to the same data.
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A register that is computerised has other benefits, such as maintaining an audit trail of
adjustments, tracking KPIs on confirmations and enabling pre-programmed automated
computer verification of transactions against benchmark rates for the day, such that
off‑market, potentially fraudulent trades can be detected. Finally, with the new, onerous
documentation requirements of IAS 39 Financial Instruments: Recognition and Measurement,
a register can be used to maintain the required information under this accounting standard.

• Independent confirmation process. Many accounting disasters dealing with derivatives have
been caused by the lack of an independent confirmation process. A strong internal control
environment would be reflected by a back office that confirms all trades independently from
the front office. Once a transaction is approved by the front office and inserted in the treasury
system, a confirmation should be sent to the counterparty, and the back office should track
the receipt of the signed confirmation.

Controls should be in place within the treasury system to determine whether all transactions
have been confirmed within the normal turnaround cycle—normally three days. Any confirmation
not received within this timeframe should be followed up immediately. In smaller treasuries with
only a few counterparties, an effective control over the completeness and accuracy of derivative
transactions is to request a confirmation from the counterparty of all outstanding positions and
reconciling this to the listing of outstanding derivatives.

• Accounting. Controls in the accounting area are often overlooked. This can result in
last‑minute surprises, to the detriment of the organisation. Accounting for derivatives,
especially the hedge accounting requirements, are complex and onerous and carry a high
risk of error. Some of the most prestigious companies around the globe have had to restate
their results due to errors in their hedge accounting records. To comply with the complex
accounting requirements, it is recommended that a policy and procedure document be
created to detail the exact requirements of the hedge accounting process. The greater the
extent to which documentation, effectiveness tests and valuations can be automated in a
treasury system, the better.

One of the basic accounting controls is to ensure that all balance sheet and hedge reserve
balances can be reconciled to a listing of underlying transactions. As with all accounting
reconciliations, it should be in a standard format, signed off by the preparer and an
independent reviewer.

• Control self-assessment. Internal controls within organisations should be monitored to

ensure that they are operating effectively. This is frequently achieved in large entities via
a control self-assessment questionnaire that is either manually or computer generated.
These questionnaires make management accountable for key controls by having management
confirm that the controls have been operating effectively during the period. Accordingly,
the questionnaires serve to remind managers of the key controls for which they are
responsible, as well as to verify that controls have operated effectively during the period.

• Independent monitoring. In larger organisations, internal auditors are responsible for

continuing compliance monitoring against policy. In smaller organisations, compliance with
policy is usually reviewed by the financial controller.
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Business continuity issues

Another important control that cannot be underestimated is business continuity planning.
The premise of such planning is to ensure that an organisation’s critical business functions will
be available to customers, suppliers, regulators and other entities that must have uninterrupted
access to those functions. The foundation of business continuity is the policies and procedures
implemented by an organisation and includes planning for aspects such as key personnel,
facilities, crisis communication and reputation protection.

Perhaps the most critical aspect of business continuity is disaster recovery. Disaster recovery
is the process and policies related to preparing for recovery or continuation of technological
infrastructure critical to an organisation after a disaster. It should include planning for resumption
of applications, data, hardware, communications (such as networking) and other IT infrastructure.
Treasury systems should be part of any disaster recovery plan.

➤➤Question 8.5
An organisation is considering using derivatives to manage interest rate risk for the first time.
Briefly describe the risks associated with the use of derivatives and how these might be controlled.

Accounting disclosure requirements

With the continuing proliferation of international commerce and multinational corporate structures,
a need has developed for standardised accounting protocols. To that end, the International
Accounting Standards Board (IASB) has developed a set of enforceable and globally accepted
international financial reporting standards (IFRSs) and international accounting standards (IASs).
IFRS 7 Financial Instruments: Disclosures has been developed to provide protocols for financial risk
management disclosure.

Risk management disclosures

IFRS 7 Financial Instruments: Disclosures has two key objectives. The first is to show the
significance of financial instruments and the second is to provide stakeholders with enough
information to assess the extent of risks arising from financial instruments. With those aims in
mind, the standard sets out both quantitative and qualitative disclosures about the risks involved.
Typically, these risks will include credit risk, liquidity risk and market risk. These disclosures need
to be included in the financial statements or incorporated in a clear cross-reference to the
financial statements.

For each type of risk faced by an entity, it must make a disclosure, including an explanation of
how the exposure arose, the entity’s objective, policies and processes for managing the risk and
the method of measurement. Any changes from the previous reporting period should also be
reported. The importance of accuracy in presenting this information should not be understated,
as directors and the company could be sued for presenting erroneous information. Furthermore,
unlike the accounting numbers that are extracted from the general ledger, the financial risk
information needs to be extracted from special treasury reports and is usually collated by the
treasury staff, if present. It is important that finance staff ensure any financial risk information
reconciles with other finance information in the accounting information system.
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Other required disclosures for derivatives include:

• the nature of the hedge relationships;
• the classification of the derivative—being fair value though profit and loss, cash flow hedge,
fair value hedge, hedge of a net investment;
• the liquidity profile of derivative liabilities;
• the basis for measuring the fair value of derivatives and, to the extent that there is significant
subjectivity in the valuation of the derivative, the potential impact of the subjective input;
• the classification of the valuation into category 1, 2 or 3—1 being a valuation based on a
quoted price in an active market, 2 being a valuation based on inputs from quoted market
prices and 3 being a valuation based on non-observable data;
• the timing of the release of the cash flow hedge reserve balance from the hedge reserve to
the profit and loss; and
• the amounts recorded in the profit and loss due to: the cash flow reserve transfer from the
reserve account; ineffectiveness and fair value changes in the derivative in the fair value
hedge and the underlying hedged item.

Case Study 8.2: Centro Properties Group

In August 2007, Centro Properties Ltd, an ASX-listed real estate investment trust, stated in its preliminary
annual reports for the year ending July 2007 that it had no current interest-bearing liabilities on its
balance sheet. This suggested that, at least in the short term, Centro had very little refinancing risk.

Just over one month later, Centro returned to the market with its final annual report. This time Centro
admitted to having over $1 billion in current interest-bearing liabilities.

This was followed by a stream of trading halts and announcements to the market by the company
that revised down earnings and admitted to increasing levels of refinancing risks. By the time the final
position at 30 June 2007 was finally settled in February 2008, the company admitted to having more
than $2.7 billion in current interest-bearing liabilities.

The share price during this period crashed from a peak of over $10 per share in mid-2007 to just
23.5 cents in March 2008, a staggering loss of over 97.5 per cent!

At this time, many shareholders in Centro Properties began a class action lawsuit against Centro
(Blackburn v. Centro (2008)), claiming it breached regulatory requirements to continually disclose
information and ‘engaged in misleading and deceptive conduct by failing to adequately disclose’:
• the full extent of their maturing debt obligations;
• the risk that they may not be able to refinance their maturing debts at forecast cost or at all; and
• the risk that there was no longer a reasonable basis for their respective profit forecasts.

Source: Maurice Blackburn Lawyers 2008, accessed May 2010, http://www.mauriceblackburn.com.

au/areas-of-practice/class-actions/current-class-actions/centro-class-action.aspx.

[In October 2009] ASIC launched civil penalty proceedings in the Federal Court of Australia
against current and former directors and a former Chief Financial Officer (CFO) of various
entities within the Centro Properties Group and Centro Retail Group (CER) (Centro) … ASIC is
seeking orders to disqualify the directors and officer from managing corporations and will
ask the Court to impose pecuniary penalties on them …
ASIC alleges that these directors and officer failed to discharge their duties with due care
and diligence in approving the financial reports for Centro Properties Ltd, Centro Property
Trust and Centro Retail Trust for the year ended 30 June 2007.
ASIC contends that these financial reports contained material misstatements, specifically,
a significant amount of interest-bearing liabilities of each of the relevant entities were wrongly
classified as non-current liabilities, rather than current liabilities. This resulted in the relevant
entities not complying with the applicable accounting standard.

Source: Australian Securities & Investments Commission 2009, ‘ASIC commences proceedings
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against current and former officers of Centro’, ASIC, 21 October. © Australian Securities &
Investments Commission. Reproduced with permission.
 514 | CONTROLLING RISKS

In respect of the civil action, investors were awarded $200 million in Australia’s biggest ever class-
action settlement. This was borne by the company, insurance proceeds and the company’s auditors.
In addition, the directors were disqualified from managing corporations and the company’s auditor
was also suspended.

Accounting standards require disclosure of how the company manages risks associated with
financial instruments, including how it:
• manages liquidity risk:
–– interest rate and foreign exchange risk;
–– credit/counterparty risk; and
–– capital structure (i.e. the ratio of debt and equity);
• manages the maturity analysis of liabilities; and
• discloses any breach of covenants.

If it is found that the company’s disclosures were incorrect or misleading, both the CFO and the
board may have a case to answer to shareholders. It is important to note that the accounting
disclosure covers significantly more than just the numbers. Specifically, the qualitative disclosures
IFRS 7 requires:
For each type of risk arising from financial instruments, an entity shall disclose:
(a) the exposures to risk and how they arise;
(b) its objectives, policies and processes for managing the risk and the methods used to
measure the risk;
(c) any changes in (a) or (b) from the previous period (IFRS 7, para. 33).

The Centro case highlights the importance of ensuring that all the information is accurate,
as well as ensuring that the company is managing the various financial risks in the manner that
is described in the financial statements.

For example, in respect of capital structure, IAS 1, paragraph 135, requires ‘qualitative
information about its objectives, policies and processes for managing capital’. In response to this,
notes to the accounts will frequently state:
The Group manages its capital to ensure that entities in the Group will be able to continue as going
concerns while maximising the return to stakeholders through the optimisation of the debt and
equity balance. The Group’s risk management committee reviews the capital structure of the Group
on a semi-annual basis.

In the event that the capital structure is not sufficient for the company to continue as a going
concern, in Australia one might expect ASIC and/or a liquidator to investigate whether
management and directors had managed the company in the way described. Any failures in
the way financial risk is managed, as noted in the accounts, would amount to a misleading
statement with related legal ramifications.

Case Study 8.3: Bright Gold Corporation—Part 2

This case study looks at the application of this module’s risk control discussion to the details of
Bright Gold Corporation that were outlined in Case Study 1.3 in Module 1. Please review the case
background provided in Module 1 before proceeding.

Part 2 of the case study considers Bright Gold’s risks and how these could be controlled and thereafter
monitored to ensure that the controls continue to operate effectively.

The first step would be to have a workshop for relevant board members, management and staff to
consider the financial risks facing the company. This workshop would review the significance of each
risk, the controls in place to control the risk and finally whether any monitoring takes place to ensure
the controls continue to operate effectively. Such a workshop might produce a risk and control matrix
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that captures the financial risks shown in the following risk and control matrix.
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Example of a risk and control matrix

No. Identified Likelihood Consequence Control

risk

1. Gold price High High 1. Strategic finance session presented to

the board annually, covering strategy of
managing financial risks, implementation
program and how it will be monitored
for effectiveness. To assess the strategic
plans, various stress scenarios are utilised
to ensure risks are fully understood and
managed in accordance with the risk
appetite of the board.
2. Financial risk policy and procedures
2. Funding High High established—subject to annual review
3. Liquidity High High internally (as part of strategic finance
session) and three-year review by an
4. Misuse of Rare High independent specialist.
derivatives 3. Monitoring of policy compliance monthly
by management. All breaches are
reported to the audit committee; serious
breaches will be reported to the CEO
and audit chair immediately.
4. Reporting to the board monthly, including
certification of policy compliance.
5. Internal audit reviews the treasury area
every three years.

5. Financial Rare High Control register has been established over

reporting of the accounting for derivatives.
derivatives (See the control register at the end of
this case study.)

As a result of the workshop, directors have queried how the use of derivatives is controlled and have
requested documentation of the controls in place and how they are being monitored to ensure the
financial statements are correct. Given this is a mid-sized company, having the monitoring undertaken
during the year by the financial controller would be acceptable.

Using the COSO framework

Control environment
The control environment of Bright Gold Corporation is assessed as strong on the basis that the
board has established a strong compliance culture based on high ethical standards. The board has
communicated this by setting out clear and concise policies in key areas and requires management to
report against these policies. In particular, in respect of accounting, the board audit committee reviews
the accounting policies annually for changes and specifically reviews any accounting treatments that
involve significant judgment or estimates and could have a material impact on the results.

For example, when the company was initially subject to IAS 39, the standard raised a number of
interpretational issues as to how Bright Gold’s hedging approach would comply with the standard.
In response, the board requested that a hedge accounting policy document be prepared outlining
how the company would comply with IAS 39 and any interpretations that were made at the time of its
creation. As part of the board review of the policy document, it was confirmed that the auditor was
comfortable with the company’s interpretations documented in the policy.

The board audit committee has also approved the internal controls of the company to ensure major
financial risks have been appropriately covered by effective internal controls. To ensure major risks
were identified, a risk management framework was also established to identify and assess risks to
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the company.
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Risk assessment
The risk assessment of the company identified accounting for derivatives as a major risk area given
the potential for loss that could arise if the derivatives were not appropriately controlled.

Control activities
The board has approved a financial risk management policy that documents the risks associated with
derivatives and the controls that the company has in place to deal with those risks. The policy covers
all the key risk areas of derivatives, being:
• liquidity and funding risk;
• market risk;
• counterparty risks;
• legal risks; and
• operational risks.

The policy has been compiled with the assistance of specialists and is regularly updated to ensure
that it is kept up to date.

In addition, a hedge accounting policy has been prepared and approved by the board. This policy sets
out the complex accounting requirements of derivatives to ensure that they are accurately recorded
in the financial statements of the company, and are in accordance with standards such as IAS 39.

Monitoring
The processes associated with the controls of derivatives are monitored at a management level and also
via the board. These processes are also documented in the financial risk management policy.

Applying COSO
While the company does not seek or purport to be COSO-compliant, it has decided to use the COSO
methodology as a check on the completeness of its internal control of derivatives and their recording
in the financial statements. The following steps have been prepared in relation to the objectives for
financial reporting discussed earlier in the module.

1. Identify the financial statement accounts affected by the process being documented.

Derivative instruments affect the following accounts:

– other assets;
– other liabilities;
– hedge reserve (equity);
– hedge ineffectiveness (P&L); and
– hedge gains and losses (P&L).

2.  rovide information on how transactions are initiated, authorised, recorded, processed and
P
reported.

Derivatives can only be approved by the treasurer in accordance with the board-approved financial
risk management policy and only with the three authorised counterparties to the policy. The
policy also dictates the types of derivatives that are authorised and the timing set against highly
probable gold sales and interest payments.

The financial accountant is responsible for ensuring that all derivatives, once transacted, are
immediately entered into the treasury system and that confirmation notes are received from the
counterparties within 24 hours. The financial controller is to be notified immediately if:
– any derivatives are executed outside of policy; or
– confirmations do not arrive within the timeframe specified.

A detailed hedge accounting policy has been agreed with the auditors that sets out the accounting
policy and procedures for derivatives. All accounting and reporting is done in accordance with
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this policy.
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3. Identify all key decision points within a process.

Key decision points are as follows:

– Board-approved policy and board-approved hedge accounting policy—both policies are
comprehensive and have been put together with the assistance of specialists, and the hedge
accounting policy has been checked by the external auditors as to compliance with accounting
standards.
– Treasurer executes transactions in accordance with policy.
– Accountant monitors compliance with policy and records derivatives in accordance with the
accounting policy.

4. Provide information about each type of transaction and the flow of transaction activity to
identify where material misstatements arising from error or fraud could occur.

Types of derivatives—forward gold contracts, foreign exchange contracts and interest rate swaps.

Flow of transactions
All transactions are treated in the same fashion.
(a) Transactions must be authorised by the board policy prior to execution.
(b) Transactions can only be approved by the treasurer or financial controller.
(c) Transactions must be put into the treasury system and confirmed within 24 hours by the back
office.
(d) The settlements officer arranges delegated signatures in accordance with policy to settle the
transactions.
(e) The accountant is responsible for recording derivatives in accordance with the hedge
accounting policy.
(f) Valuations of the treasury system are reconciled with the bank’s valuations quarterly to ensure
that they are correct.
(g) The accountant uses a presentation and disclosure checklist in conjunction with model
guidelines provided by the auditors to check that the presentation and disclosure of derivatives
in the accounts are correct.

5. Evidence the identification of controls and the communication of responsibility for performing
those controls.

A control register is provided at the end of this case study to evidence all controls over potential
errors.

6. Confirm the alignment of risks and controls.

This is evidenced in the control register by the completeness of control objectives for the risks
identified.

7. Distinguish between key controls and other controls identified.

This is evidenced in the control register.

8. Indicate the steps to be undertaken should the controls identified detect a failure
or an exception within the process.

The policy requires:

(a) reporting of all breaches to the board along with the date and circumstance of the occurrence;
(b) explanations of how the breach occurred (system failure, oversight, lack of training or wilful
disregard);
(c) consequences of the event, including any effect on profit or loss (the circumstances should
be investigated even if profit resulted from the non-compliance);
(d) a note of remedial action taken or proposed; and
(e) a note of any follow-up action required.
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9. Confirm the identification of changes to internal control processes or environment.

Whenever a policy or procedure is changed, the control register and the risk and control matrix
will be updated accordingly.

10. Provide information on the IT systems used in the management and/or derivation of financial
information (i.e. general ledger, spreadsheets, other IT applications) and clarify the interface,
within the control environment between finance and IT systems.

The company uses a proprietary web-based treasury system to record all derivatives and to
produce the accounting entries. A general computer-controls audit report is produced by the
IT company providing the web-based system. This system is interfaced with applicable general
ledger accounts, and controls are in place to ensure system listings agree with the balances in
the balance sheet accounts and the movements in the profit and loss accounts. Management
monitors the output of the system by:
• reviewing and approving all reconciliations;
• agreeing valuations to bank valuations at month end; and
• comparing the budgeted profit and loss results from derivatives to actual results and explaining
any differences.

11. Verify handover points between service providers within the company.

This is demonstrated by the control register at the end of this case study.

The control register at the end of this case study is an example of a template for documenting financial
reporting controls. It has been reduced to only cover key areas. A full template would also include
columns to provide evidence of the following:
• the frequency of the control;
• whether it is automated or manual;
• the nature of the tests performed to verify the control;
• the results of those tests;
• management’s assessment and testing of the controls;
• any changes in the system;
• updates to reporting date;
• sign-off, a conclusion on the operating effectiveness of the process; and
• details of the response to any deficiencies found in the documented controls.

To determine the adequacy of the control register, it is worth checking to see whether there are controls
covering the key account assertions of:
• existence and occurrence;
• completeness;
• accuracy;
• rights and obligations; and
• presentation and disclosure.

From the control register, it can be seen that all these potential errors are covered by the controls
in place.
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The function of each column in the control register is outlined below to clarify its use as a diagnostic tool.

Control activity code. All controls should have a unique ID to document and subsequently monitor.

Control activity description. This section describes the exact nature of the control activity.

Related control objective(s). This section describes the potential error assertion that the control
seeks to protect—see Table 8.3 for a detailed list of all assertions.

Does the control mitigate a significant risk? This section highlights whether the control addresses a
significant risk or not. Note that some controls are designed to manage areas of comparatively low risk.

Reference/response to mitigating control activities. This section describes whether there are any
additional mitigating controls in respect of the same control objective.

Design of the control activity. This section describes the specific control activity.

Is the control activity preventative or detective in nature? This section covers the types of controls.

Is the control activity properly designed? This section provides a conclusion on whether the control
is properly designed to achieve the control objective.

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520

Control register over financial reporting of derivatives

Design of control activities

Reference/
Does the response Is the control Is the
| CONTROLLING RISKS

control to activity control

Control mitigate a mitigating preventative activity
activity significant control or detective properly
code Control activity description Related control objective(s) risk? activities Design of the control activity in nature? designed?

1 There is a board-approved policy Only valid transactions are Yes NA A financial risk management Preventative Yes
over the use of derivatives and executed and such transactions policy and hedge accounting
the accounting for derivatives. are accurately recorded. policy are approved by the
Compliance with board limits and board, and financial controller
policy is confirmed each period confirms compliance with
by the financial controller. these policies.

2 All derivatives are executed and Transactions exist, are completely Yes NA Accountant verifies all trades Preventative Yes
approved by the treasurer in recorded, and reflect rights and and agrees details to external
accordance with the approved obligations/existence of the confirmations.
policy. The accountant reviews company.
approved transactions for
compliance with the policy, signs
documentation and ensures
confirmation is obtained.

3 A third-party treasury system Transactions are accurately Yes See also Accountant signs off Detective Yes
is used to record all trades recorded and valued at the end 4 and 5 reconciliations of balance sheet
and value transactions of each period. and profit and loss account.
based on month end prices.
The accountant signs off
reconciliations to the balance
sheet and profit and loss.

4 The treasury system valuations At period end, transactions are No See 3 Accountant compares external Detective Yes
and outstanding positions are valued accurately, rights and derivative valuations to
compared by the accountant obligations of the company exist, system valuations.
to external valuations and and are completely recorded.
statements of position provided
by the counterparties.
 Control register over financial reporting of derivatives

Design of control activities

Reference/
Does the response Is the control Is the
control to activity control
Control mitigate a mitigating preventative activity
activity significant control or detective properly
code Control activity description Related control objective(s) risk? activities Design of the control activity in nature? designed?

5 The accountant compares the Transactions are accurately No See 3 Accountant compares actual to Detective Yes
actual profit and loss from recorded at period end. budget and explains variances.
derivatives with the budgeted
profit and loss and explains any
variations.

6 Settlements of derivatives are Transactions are accurately No See 3 Settlements are authorised in Preventative Yes
arranged by the settlements clerk recorded at period end. accordance with delegated
who ensures that the appropriate authority.
signatures are in accordance with
the board delegation per the
policy.

7 The presentation and disclosure Presentation and disclosure are Yes NA Financial controller reviews Detective Yes
in the accounts are prepared accurately made. and approves presentation and
by the accountant based on disclosure.
checklists and model accounts
provided by the auditors.
Presentation and disclosure are
reviewed and approved by the
financial controller.

8 The accountant and treasurer Disclosure of derivatives. No See 7 Report to the board. Detective Yes
prepare a paper to the board
each quarter reflecting derivative
positions against limits.
Study guide |
521

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Review
Over the last few years, corporate governance and compliance requirements for boards have
proliferated to such an extent that board membership has become an onerous and potentially
personally risky undertaking. Ensuring that an appropriate risk management framework and
control environment is in place is a major responsibility of every company director.

Failures of controls at organisations have led to severe losses for stakeholders and civil as well
as criminal proceedings against directors and company officers. Directors cannot rely on a lack
of special knowledge or on auditors’ reports to protect them from accidental or deliberate
misstatements as to the accuracy of financial reports.

This module has outlined a series of practical approaches that can be taken to minimise the
specific financial and operational risks facing an organisation using models based on analysis by
Standards Australia, COSO and the ASX Corporate Governance Council.
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Appendix
Appendix

Appendix 8.1
This appendix discusses:
1. a financial risk management checklist;
2. choosing a treasury system;
3. Barings—Lessons in risk management; and
4. National Australia Bank (NAB) insights.

Financial risk management checklist

Having discussed in detail the fundamental financial risk management exposures which
companies face, the questions below may provide the risk management professional or a
company director a starting point in assessing the state of financial risk management in their
organisation. They may also help in the preparation of the information to be included in the
annual report on management systems and internal controls. This list is not exhaustive and
should be modified or expanded according to an organisation’s size and complexity.

Policies and procedures

• Has the board made a formal decision about the level of financial risk that is acceptable?
Has the board decided whether to remain unhedged, partially hedged, fully unhedged,
or even, perhaps, to deliberately incur financial risks as a means of potentially
increasing profits?
• Have policies been documented and communicated to management, and is it clear
that they are understood by management and staff?
• Have policies been determined for financial management activities in general and,
in particular, for financial risks to be managed by authorised transactions?
• Are procedures in place to define and control the operations of financial risk
management staff?
• If speculative financial risk management transactions are prohibited, what procedures have
management established to ensure that none have been undertaken?
• Are shareholders aware of the attitude to risk (the organisation’s risk appetite) that has been
determined by the directors?
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Risk identification and controls

• Has a thorough effort been made to identify all current and potential financial risks?
• Have these financial risks been hedged in accordance with policy, and what are the current
exposures and values of the risks and hedges on a mark to market basis?
• Does management monitor and control the use of financial instruments to manage risk?
• Is there an appropriate and effective system of internal controls, and is there clear
segregation of duties between staff dealing in contracts and those responsible for
confirmation, settlement and accounting?
• Are transactions subject to independent assessment and review, for example, by internal
audit and external audit?

Risk management
• Is the management structure clear and is there an appropriate level of delegated authority
for different types of transactions?
• Are staff appropriately experienced and adequately trained for the complexity of transactions
they undertake?
• Does the system of remuneration reward results after taking into account the degree of
exposure risk, thus avoiding the situation where a dealer can expose the organisation
to unacceptably high risks for purely personal reward?

Compliance
• Has management ensured and certified to the board that relevant operations have complied
with the company’s financial risk management policies and procedures?

Accounting
• Are the results of transactions reported on a timely basis?
• Have exposures been valued with appropriate frequency? Have external rates been used
and is the valuation sufficiently independent of dealing staff?
• Has it been confirmed that all liabilities are included in the financial statements?
• Are there any unrealised losses at year end that have not been recorded in the accounts?
• Do the systems and processes enable production of all required accounts and disclosures?

Cash flow/liquidity
• Has a detailed cash flow forecast for the current year and the following financial year been
prepared and reviewed by senior management before presentation to the board?
• Are all loan repayments and capital commitments included and are any new or renewed
borrowing facilities committed or uncommitted?
• Is the company able to pay its creditors and debts as they fall due?
• Does the company have sufficient cash to pay any proposed dividends, taking into account
other cash commitments?

Choosing a treasury system

Introduction
Treasury departments have benefited from significant software and hardware technological
advances in recent times; these advances have resulted in accelerating processes and distribution
of business information. The efficiencies associated with prompt delivery of information have
enabled business decisions to be made more promptly. The number of transactions is often
voluminous and the need to quickly assimilate information in order to make a decision or to
mitigate financial risk is of high importance. The quantity and timeliness of the data directly
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affect the quality and urgency of the decision-making process.

 Appendix 8.1 | 525

These added efficiencies can be attributed to technology, which has greatly assisted in the
gathering and processing of this information. The use of centralised mainframe computers
and batch processes yielded first to personal computers (PCs) and local area networks and,
more recently, to completely decentralised web-enabled software solutions. Advanced software
tools available to programmers have allowed them to create methods of processing data that are
much more efficient and timely than ever before. For example, time-consuming file uploads and
downloads are being replaced by more efficient straight-through-processing (STP) capabilities.

The improvements to business processes which technology and software designs enable should
be reviewed from time to time, ensuring that the functionalities are aligned with the treasury
operations requirements. It is important to employ the right technology when and where it is
most appropriate. A distinction should be made between those business processes that can
benefit from technology-enabled decentralisation and those that depend on centralisation to
be the most effective and efficient means to handle the data. Just because technology facilitates
the use of decentralised data collection, it might not always be the appropriate approach for
downstream business processes. Decentralised data collection certainly makes sense by pushing
the data input requirements out into the field, thus relieving the burden from the central treasury
office by redistributing the workload. Centralised analysis, on the other hand, is critical to
assimilating the data and making the right decisions.

Treasury departments of large and medium-sized corporations often become the focal point for
many tasks involving centralised decision-making based on decentralised data. For example,
the consolidation and investment of a company’s excess cash is, by its very nature, a centralised
operation that requires information from many sources. Likewise, short-term borrowings
(commercial paper issuance, the use of credit facilities etc.) are best determined by a single,
centralised decision-maker once the data from many sources is brought together and analysed.
The benefits from decentralisation result from the redistribution of workloads from a few
individuals to many, as well as the familiarity that results from being closer to the source of
the data. On the other hand, the benefits from centralisation are better decision-making and
a reduction in the need to maintain multiple personnel with specialised areas of expertise
(e.g. trading, cash management, investment and borrowing), not to mention the costs associated
with the decision support structure (Bloomberg or Reuters terminals, multiple software licences,
specialised training etc.).

One of the largest data-gathering requirements of a typical multinational corporation’s treasury

department involves the collection of its external and inter-company foreign exchange exposure
data. Not only is the number of transactions typically large, but also the decisions to be made
concerning the data usually have important financial repercussions. External foreign exchange
exposures, such as sales forecasts or foreign currency cash balances in a bank, are typically
consolidated and hedged by central treasury. Inter-company receivables and payables may be
settled by means of a multi‑lateral netting process, also under the control of central treasury.
Both processes involve the collection of vast amounts of data from many sources, but rely on
a centralised decision-making capability to be effective.

Until recently, a company’s forecasted or actual foreign exchange exposure information was
collected from subsidiaries around the world and manually consolidated by central treasury
personnel. Although some companies may have required that their subsidiaries use standard
input formats, other companies relied on an assortment of non-standard faxes, emails and
telexes to collect their data. Either way, the exposure information had to be manually uploaded
or rekeyed into the centralised exposure management program before it could be used for
decision-making. The process was time-consuming and error prone, at best.
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Today, however, companies rightly insist that this process be streamlined to remove as many
manual procedures as possible. By using web-based technologies and good systems design,
treasury software vendors are able to provide solutions that allow for a continuous flow of
business information. By logging onto their web browsers, subsidiaries can input their exposures
or inter-company payables and immediately run reports to verify their positions. The central
treasury office can review these transactions in real-time and accept or question individual
transactions as appropriate. The key concept is that there is one point of entry for the information
into the system. After that point, the data can be reviewed, rejected, corrected or accepted as
appropriate without having to re-input the entire transaction. The ability for users of the system
to communicate with others from within the system itself makes the process all the more efficient.

Entire business flows are designed and built into today’s systems. The ‘black box’ that used
to process transactions is now a transparent box, allowing the data to be reviewed by all
concerned participants. A well-designed system will simultaneously provide the ability for many
users to collaborate in real time in order to solve problems of mutual interest. For example,
as soon as a netting participant provides its inter-company payables into the netting system,
the corresponding receivables participants have the ability to review and challenge the entries
before the actual netting process takes place. Likewise, as soon as central treasury hedges
an exposure on behalf of a subsidiary, that information becomes available to the subsidiary.
Authorisation levels, review and approval steps, and input/feedback mechanisms are all
built into today’s better designed systems.

The key improvements that effective software design and advanced technology has
yielded include:
• real-time data availability across all time zones;
• less dependence on manual processes;
• increased accuracy;
• increased timeliness;
• increased communication;
• better decision-making; and
• increased control over the business process.

Selection of an appropriate treasury management system

As discussed above, technology plays a vital role in ensuring an efficient treasury operation.
It is therefore critical to select and implement an appropriate treasury management system
(TMS) based on the requirements of the company. Unfortunately, the process for selecting
an appropriate system can be frustrating and disappointing.

The essence of an effective TMS implementation is understanding the treasury operation’s

requirements, planning and project management. Implementing and going live with a new
system could take between three to six months. Figure A8.1 represents the process which
should be adhered to when implementing a new system.

The selection process is worth looking at in more detail.

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 Appendix 8.1 | 527

Figure A8.1: Selecting and implementing a treasury system

High level needs analysis

Developing
the
Develop specification
request for proposal
(RFP)

List suppliers
Allow 3–4 weeks

Average 3–6 months

Issue RFP

Evaluate responses
Evaluation
and
testing
Live testing

Detailed implementation plan

Selection and
negotiation
Contract negotiations

Implementation

Document user requirements

Having decided that you need a new TMS, it is vital that you document what you actually do on
a daily basis. A small project team should be established and a key point person given the task of
looking at each area the TMS touches with a view to documenting the requirements. This team
should comprise individuals from all areas where the TMS is used: back office, middle office,
front office, accounting, audit and so on. It is also beneficial to establish a steering committee
comprising project sponsors who will have final sign-off for any decision. This will ensure that
there is complete buy-in to the process and the decision is a collective one.

If you are replacing an existing TMS, particular thought should be given to what is good and
bad about the current system. Users will know what they like and dislike. The list of requirements
should lead to the selection of ‘must have now’, ‘must have in the future’ and ‘nice to have’.
The project team must agree on the list and refer back to it when evaluating the systems;
otherwise the process will become protracted and possibly lead to failure.
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Produce a vendor list

There are numerous TMS software providers in the marketplace; some are cash management
biased while others have a strong treasury instrument focus. Hence, if emphasis is on cash
management activity, for example, it is important to realise that in this area some TMSs are better
than others. If the focus is on front office requirements, some systems will be more suited to
these requirements than others. The project must clearly identify the functions/processes which
are important to their implementation, then match the requirements to the functionality in the
systems. It is beneficial to research what is available in the market and what might be suitable
to the treasury function needs by reading periodicals, trawling the Internet, buying one of a
number of TMS surveys available or buying in expert advice. Some TMS vendors also provide
a form of application service provider (ASP) hosting, via the web. ASP solutions should reduce
implementation time because there is no software to implement or support other than a web
browser. However, before committing to such arrangements, it will be necessary to ensure that
the system conforms to the company guidelines and that the company’s system can support
such technology.

It is advisable to produce a long list of vendors (up to five) to whom a request for information
(RFI) is sent. The RFI is a short document with details of the company, what the company is trying
to achieve and when it wants to achieve it by. It is useful in order to give the vendors of choice
the opportunity to decide whether to formally bid for the business or not. It also lets the project
team know whether those vendors can satisfy the company’s requirements within the timeframe
required and within the set budget. Discovering vendor pricing is important at this early stage in
the process. The project team will not be able to get exact pricing as vendors will not know the
precise requirements, but it should give a good indication if the range is within the company’s
budget. There is no point in proceeding with the perfect vendor if its pricing structure is way
beyond the company’s budget. At this point, it would also be beneficial to ensure that the vendor
can deliver the system in the timeframe required. If the vendor is unable to do this, the project
team may want to reconsider using that vendor.

In summary, the RFI is a useful step for reducing the number of vendors to a manageable level.
It should cover the following at a minimum:
• general information about the vendor—location, number of employees by category,
current turnover etc.;
• general information about the company;
• general information about what the company is looking for in a system—for example,
large debt portfolio (IAS 39); and
• any specific factors that are important—for example, must be implemented within a
certain timeframe.

Issuing a request for proposal

The next step is to formally communicate with the remaining vendors (a short list of not more
than three or four) concerning the treasury functions and a detailed list of requirements. This is
done by writing a request for proposal (RFP). The RFP process will reduce this list to perhaps
two vendors, from whom the project team will make its final choice.

The RFP should include all the relevant information and important requirements of the company.
At this point, it may also be beneficial to indicate to the vendors how the project team proposes
to evaluate the systems, ensuring that the vendor has as much information as possible to
properly respond to the question.
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The RFP can be divided into sections (e.g. front office, back office, risk management, cash
management, technical, security). The project team should also consider a weighting for each
question. This is useful because it will provide the project team evaluating the proposals with
an easy method of comparing the vendors against each other and will point out the strengths
and weaknesses of the different systems. The TMS project team should now be convened
again to compare the responses against the weightings that are formally attached to each of
the questions. It will become obvious at this stage if one or more of the vendors does not meet
the company’s criteria, in which case they can be taken out of the running. However, the project
team should not rely on the RFP response alone to make the final selection decision. Sometimes,
vendors misinterpret questions or answer them incorrectly. Therefore, the RFP should only be
used as a guide.

At a minimum, the RFP should cover the following:

• Vendor overview
–– Time the company has been in existence.
–– Financial background.
–– Strategic development and process.
–– Commitment to research and development.
–– Current list of clients.
• System functionality
–– Back, middle and front office.
–– Security and audit technology.
–– Whether the company supports the vendor technology.
• Other
–– Support and implementation policy.
–– User groups.
–– Enhancement and bug-fixing policy.

Choosing a vendor
To make the final decision, the project team needs to see and test the system. This is probably
the most important point in the process. The aim is to evaluate the system in as much detail as
possible and as close to the environment in which it will be operating. Therefore, the project
team should insist on organising a workshop where the system is demonstrated using actual
business data. If there are particular deal types or functions that are important to the company,
the project team should also ensure that they are tested on the system. As actual company data
is being used, the project team would be able to access the performance and functionality of the
system which can be reconciled to the company’s existing or legacy system and processes. It is
only through this process that the project team can be sure that the system really does perform
in the way that works for the company.

At this stage, two references should be taken up per vendor; it is best to try and visit at least
one on site. If it can be arranged, the team can physically witness how the TMS works and get a
chance to talk to the users. This is not always possible but at a minimum it should ask to speak to
the referee. Issues such as after-sales service and upgrade experience are important to explore.
The project team should choose a reference that uses the TMS in a way similar to the company’s
treasury function.

After all these steps, the project team should be in a position to select an appropriate TMS.
The steering committee can be sure that the project team followed a selection process that was
comprehensive, exhaustive and fair.
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Summary
In summary, the steps in selecting a TMS are as follows:
• Document the company’s requirements. Prioritise them into ‘must have now’, ‘must have
in the future’ and ‘nice to have’.
• Produce a vendor long list. Issue an RFI.
• Produce an RFP and shortlist.
• Reduce shortlist to a maximum of two or three. Hold vendor workshops using existing
and tried data for comparison purposes.
• Make final choice.

Barings—Lessons in risk management

The failure of Barings Bank was in many respects a watershed for risk management in financial
institutions. It led to a widespread review by financial regulators of risk management practices and
a heightened awareness of the importance of risk management in financial institutions, particularly
over the use of derivatives. While many believe that Barings’ problems were all about market risks
created from speculative derivative transactions, the root causes of the crisis are much broader
and can be traced to the very heart of the organisation itself. The lessons from the Barings crisis,
while having much to say about risk management in financial institutions, also extend well beyond
financial institutions and can be directly applied to every corporation.

Overview of the case

In essence, Barings collapsed because it was unable to meet the enormous trading obligations
that Nick Leeson, one of its traders in its Singapore operations, had established. Leeson was
the manager of the Barings Singapore futures operation, as well as transacting for clients.
He had been given authority to ‘arbitrage’ futures contracts on Japanese share and interest rate
contracts traded in Singapore with those traded in Osaka and Tokyo. At the time that Barings
went into receivership on 27 February 1995, it held outstanding notional futures positions of
USD 27 billion. To put the size of these positions into perspective, Barings reported capital
at the time was USD 615 million, and in January and February 1995 alone, USD 835 million
was transferred to Barings Singapore to cover margin calls (in essence, the unrealised losses)
on these positions.

Although complex in structure, these positions were established from very basic instruments,
namely, exchange traded futures and options contracts. Furthermore, being exchange traded
derivatives that were very much in the nature of a commodity—they were all traded, settled and
cleared through registered exchange markets.

A review of Leeson’s trading activities showed that he engaged in unauthorised trading as soon
as he was appointed to the position with Barings Singapore in 1992. Yet Leeson was considered
a boy wonder contributing around half the reported profits of Barings Singapore. From 1993
to 1995, Leeson’s activities generated an aggregate profit over the period of GBP 56 million.
In fact, Leeson’s trading never produced a profit in any period, and total losses of GBP 827 million
were incurred. He was able to conceal these losses by entering into cross trades—transactions
purporting to be between Barings’ own clients—and amending the prices of the trades to effect
a profitable outcome.

The story of how this situation happened highlights many important risk management lessons.
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The lessons from Barings

The role and actions of senior management:
1. Barings’ senior management had a very superficial understanding of the nature of derivatives
and the business carried out by Leeson. They did not appear to want to probe too deeply into
an operation that was contributing a very substantial portion of their profits. They considered
(rightly) that arbitrage activity is low risk, but failed to question how low-risk activity could
generate such high returns.
2. Senior management also failed to allocate sufficient resources to the effective management
of operational risks. An internal audit report issued before the crisis recommended
the appointment of a full-time head of back office in Singapore. This was dismissed as
unnecessary given the perceived demands of such a position.
3. There was insufficient analysis of the operation. Senior management did not have any
breakdown of the reported profit. They naively accepted that this was an extremely profitable
operation with little risk.
4. Barings had to borrow substantial cash to meet margin calls on the business. Leeson was not
pressed for details of his positions or those of clients that demanded such large margin calls.
5. The frequent warning signs, including requests for explanations from the Singapore Futures
Exchange and internal and external audits, were all ignored.
6. The culture of Barings, which excessively rewarded high achievers, promoted the environment
that encouraged individuals to take excessive risks. The culture provided Leeson with motive.

Summary
Senior management must fully understand the nature of the business before embarking on
a strategy. Adequate resources must be applied to the management of the business and its
inherent risks. The nature and risks of the business should be understood and if the business
seems to be too good to be true, it probably is.

Segregation of responsibilities
1. The fundamental rule that requires separation of responsibility for the execution of the
business and the settlement and control process, is as old as accounting itself. Leeson not
only executed the trade but was also responsible for all back office functions, including
settlement of funds, cheque signing, recording of the transactions and reporting.
2. Leeson established a hidden ‘error account’ to record his trades. He ordered the programmer
and operational staff to suppress this account from reports produced showing trade positions.
3. This lack of segregation was reported in an August 1994 internal audit, but as with many
other issues, this warning was ignored and no corrective action taken.
4. Using his position, Leeson was able to circumvent the normal control environment
established to prevent fraud or other unacceptable behaviour.

Senior management must ensure that there is adequate separation of responsibility of dealing
activities from that of managing the control environment.
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Poor control procedures

1. Control procedures at Barings were sloppy. There was no system to reconcile the funds that
Leeson requested to support margin calls (up to USD 1.2 billion at the time of receivership).
2. Despite concerns by senior operational staff in London about the accuracy of his data, it was
not investigated. Some simple calculations would have revealed that the amount of funding
sought was substantially more than would have theoretically been required to cover the
reported positions.
3. Much of the funding sought was ostensibly to cover positions of clients, yet no one made any
request for information about the clients to whom such large sums were apparently being
lent. This implies that no limits existed for the amount of credit risk taken in respect of clients.
4. There was no independent checking of the reports produced to enable management to satisfy
themselves that all risks were being identified and appropriately managed. The principle
‘garbage in garbage out’ became a truism at Barings.
5. Given that management considered Leeson’s arbitrage trading as low risk, they did not
bother to establish limits. Limits should be applied in all circumstances, including arbitrage
trading. If trading activity exceeds a level that can be comfortably supported by the
market, a risk will arise. A limit to cap activity to manageable levels should be applied in
all circumstances.
6. The external auditors concluded a review of Barings Singapore’s internal control environment
as part of its audit in November 1994, only two months before the company’s failure. The review
concluded that the control environment was satisfactory. This suggests that while external
reviews can assist in understanding the effectiveness of risk management practices, external risk
reviews are never a substitute for a sound framework of internal controls and review processes.

Control procedures are vitally important to managing risk effectively. Not only do these processes
need to be effectively drawn up, but they also need to be effectively implemented. Controls
should ensure that operations are subjected to adequate review and reconciliation, and that
appropriate limits are set and monitored at all times. Poor control procedures will quickly allow
the operation to get out of control.

Supervision and organisation structure

1. An interesting feature of Barings’ organisational structure was that it adopted a matrix
structure. While this structure is not uncommon and is conceptually sound, if senior
management fail to implement the structure effectively, the result will be that little to no
accountability exists throughout the organisation.
2. Leeson’s reporting lines were unclear and ranged from a regional supervisor in Tokyo,
a regional operations manager in Singapore, the head of financial products in London,
the global head of equities in London and the head of equity derivatives in Tokyo. Each one
believed that Leeson was reporting to someone else, so he effectively reported to none.
3. The questions raised by the Singapore Futures Exchange in early 1995 could only be
answered by Leeson, and it appears that he was left largely unsupervised. This matter should
have received careful management attention.
4. A large anomaly identified by the auditors in early 1995 was not sufficiently well investigated.
Again, the level of supervision over Leeson’s activities appears to have been wanting.

Management must ensure that not only do clear lines of reporting and accountability exist,
but that these result in adequate reporting and accountability being given and received
at all times.
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Conclusion
Many commentators lay the blame for the crisis at Barings solely at the feet of Nick Leeson.
Whilst there is little doubt he embarked on a course of action designed to deceive and obscure
the true nature of his activities, it is also true that the environment in Barings was conducive to
such activity.

Leeson implemented a regime of deceit but Barings’ culture, structure and control environment
provided him with the opportunity and the ability to carry out his activities for years. This was a
major factor in the demise of Barings.

National Australia Bank (NAB) insights

Table A8.1 summarises some of the critical findings associated with the NAB trading scandal.
It should be noted that the NAB incident arose in a trading section of a major financial institution
and hence many of the controls will not be applicable to every company. Nevertheless, as a
control self-effectiveness exercise, it would be beneficial for each treasury operation to identify
whether it has controls in place which mitigate the operational risk issues mentioned.

Based on the operational risk principles discussed, reflect on the critical processes which NAB should
have had in place to mitigate each of these issues. No suggested answers have been provided.
This activity is provided for you to reflect on the operational risk principles discussed in the module.

Table A8.1: Analysis of NAB derivatives trading case

Issues Applicability to your treasury

1. Governance

1.01 There was no formal policy requirement for limit Does a formal policy or governance
breaches to be rectified. framework exist?

1.02 There was a lack of clarity in relation to the division Does the policy/framework clearly
of responsibility between Corporate & Institutional define the responsibility of all key
Bank (CIB) management and Market Risk & Prudential functions?
Control (MR&PC).

1.03 MR&PC felt it had no authority to enforce limit Are all limit breaches investigated and
compliance; this activity was not supported by the thoroughly documented?
Executive General Manager Group Risk. MR&PC did
not escalate persistent breaches of limits beyond
Markets Division management.

1.04 Multiple limit breaches (e.g. value at risk (VAR), delta Are all limit breaches investigated and
and vega) were routinely approved by Joint Head thoroughly documented, including
Global FX and/or GM Markets Division without actions required by management?
rigorous investigation or any action being taken to
reduce exposures.

1.05 Breaches of desk VAR limits were only required to be Are all limits reported to the
approved by the relevant trading and global product appropriate committees?
head (Joint Head Global FX).

1.06 Limit breaches were grouped together in an electronic How are consolidated breaches
database and approved in total by the Joint Head FX. reported?

1.07 Both soft and hard limits were in place for the Does your treasury have hard and soft
desk, resulting in confusion on enforceability and limits?
applicability of policy.
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Issues Applicability to your treasury

1. Governance

1.08 There was no formal independent review of the Are valuation models created
reasonableness of certain parameters used to revalue independently from the front office?
the currency options portfolio (e.g. revaluation rates).

1.09 Large and unusual deals were not investigated Does middle or back office have
or reported (e.g. deep in-the-money options and sufficient understanding of the front
structured deals). office to monitor its activities?

1.10 There was no review of deals done at off- Can the treasury system detect
market rates. off‑market trades?

1.11 New product approval processes were breached with Are new treasury transactions subject
relative impunity. The desk engaged in transactions to independent approval process?
(e.g. complex or structured deals) before approval
procedures were completed. Deal approvals were
often backdated to cover transactions.

1.12 There was a long-standing lack of confidence in Is the company confident in VAR results?
VAR results by management and the desk
(for at least three years); hence, limit breaches
were considered a ‘systems issue’ and effectively
ignored. No compensating controls were put in place
or limits/activity reduced to manage this situation.

1.13 Although VAR could not be calculated with Are new products subject to an
confidence, trading in new transaction types independent approval process?
were approved without being restricted (in size or
volume etc.) or additional scrutiny being required.
No compensating controls were put in place.

1.14 There were failures in risk reporting at all levels: Are all beaches of policy reported to
• VAR limit breaches for the desk were removed the board?
from the daily risk report;
• reports to the Principal Board Risk Committee
(PBRC) focussed on overall Markets Division
exposure against limits—nothing was reported on
exposure and limit breaches for individual desks;
• the Principal Board Audit Committee was not
aware of the continuing limit breaches; and
• reporting to the board lacked sufficient detail
for board member to be aware of the risks being
undertaken and any relevant issues (e.g. limit
breaches).
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Issues Applicability to your treasury

2. Processes

2.01 There was no formal reconciliation between the Are treasury results regularly reconciled
general ledger and management profit and loss. to the accounting records?

2.02 False spot FX and currency options transactions were Front office should be limited
entered into the trading system (Horizon) to conceal to initialising deals. Changes to
losses; these deals were cancelled (surrendered) prior transactions can only be done by
to settlement. Incorrect deal rates were entered and the back office.
corrected at a later date.

2.03 There was no audit trail review to check amended Is there a complete audit trail?
or cancelled (surrendered) deals.

2.04 Back office ceased confirming all trades (did not Have all trades been confirmed on
confirm internal deals). The relevant managers were a timely basis?
not aware that their back office staff were no longer
following agreed procedures.

2.05 There was no formal reconciliation of the outstanding Are all intra-company positions
internal deal position between desks (e.g. currency agreed?
options desk and spot FX desk).

2.06 Internal audit did not follow up results of action plans Did internal audit clear all matters
to ensure that agreed activities had been undertaken raised?
and that issues had been addressed.

Issues Applicability to your treasury

3. Management/culture

3.01 Corporate strategy was not enforced at the desk level: Does middle and/or back office fully
• corporate strategy—focus on sales of products understand the activities of the front
to corporate and institutional clients, market office?
making and proprietary trading to support price
competitiveness and execution capabilities for
the customer business;
• trading income to be 30 per cent of
total income; and
• actual activity undertaken by the desk focussed
on proprietary trading (including complex
transactions and structured deals).

3.02 Aggressive profit targets were set that may have Do targets reflect the nature of the
been inconsistent with corporate objectives—the business?
desk budget was AUD 37 million (for four traders).

3.03 Weaknesses in management approach: Did management fully understand the

• limited day-to-day supervision of traders by nature of business, including the risks
Joint Head Global FX; involved?
• management focus was on results; there was less
focus on risks and the nature of the transactions
being undertaken;
• general lack of understanding of profit and loss,
positions and actual ‘riskiness’ of actions by
management;
• warning signs were not properly and fully
responded to (from other banks and APRA); and
• aggressive trading culture was allowed to exist.
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Issues Applicability to your treasury

3. Management/culture

3.04 Weaknesses in executive approach: Does senior management understand

• senior and executive management the risks? Has the board been advised
demonstrated a lack of adequate appreciation of all breaches?
of risk involved in trading currency options;
• PBRC only focussed on high-level ‘overall’ limits
and activities—limits and breaches for each desk
were not considered or reported;
• warning signs were not properly and fully
investigated; and
• board was not fully informed of activities,
risks and positions.

Issues Applicability to your treasury

4. Systems

4.01 Use of disparate, non-integrated systems enhanced Is treasury system information

the ability for fraudulent activity to occur. transparent and readily
understandable?

4.02 As a result of a lack of integrated systems, there was Has front office any access to
a one-hour ‘window of opportunity’ where traders transactions
could incorrectly record genuine transactions or enter after initiation?
false transactions. These would be included in general
ledger results, then reversed out prior to end-of-day
procedures starting.

4.03 System issues in relation to confidence in the VAR Is the culture such that breaches are
calculation were outstanding for approximately routinely approved?
three years, and the resolution of issues was not a
high priority.
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Reading
Reading

Reading 8.1
How sons of Lalor built, then sank, Sons of Gwalia
Mark Drummond

Once the golden boys of the WA mining industry, Sons of Gwalia chiefs now face an explosive
series of allegations.

Brothers Peter and Chris Lalor were not so much part of the mining industry establishment in
Perth as they built Sons of Gwalia into one of Australia’s biggest gold companies.

For the best part of two decades, the Lalors pretty much were the establishment.

Like their company, the Lalors were steeped in mining history.

Born in Narrogin, the brothers were descendants of the Peter Lalor famed as leader of the
Eureka Stockade revolt in the Ballarat goldfields in 1854.

The mining company the Lalors founded in 1981 built its fortune reviving one of WA’s most
famous mines, the old Sons of Gwalia mine near Leonora. Over 67 years, the mine had yielded
2.5 million ounces of gold before its closure in 1963 turned the Gwalia settlement into a ghost
town. The mine was also famous because it was founded and managed by Herbert Hoover,
who went on to become the 31st president of the United States.

As their Gwalia empire grew over two decades through a series of takeovers and mergers, so too
did the stature of the Lalor brothers within the gold industry and the broader community.

That was best reflected in Peter Lalor’s resume. He was president of the WA Chamber of Minerals
and Energy, inaugural director of the World Gold Council, deputy chairman of the Australian
Gold Council and chairman of the Federal Government’s Action Agenda into mineral exploration.
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When Sons of Gwalia shares traded above $10 in 2001, the Lalors’ company had broken into
the $1 billion league.

With a reputation for conservatism, the Lalors appeared to become confrontational only
when stockbrokers put a sell recommendation on their stock or the financial press portrayed
Sons of Gwalia in any sort of negative light.

‘They certainly made themselves out to be the doyens of the industry,’ one Perth broker
said yesterday.

All of which made the collapse of Sons of Gwalia last year so spectacular. It was also why the
conclusions drawn by the Sons of Gwalia administrators, after almost a year of investigations,
are so explosive.

The 185-page report centres around the foreign exchange trading and gold hedging activities
undertaken by chief financial officer Eardley Ross-Adjie which, dating back to the mid-1990s,
set the company up for its ultimate implosion.

In particular, the administrators claim in their report that unauthorised gold and foreign exchange
trading activities undertaken by Mr Ross-Adjie in the year ended June 30, 2000, ended up costing
Sons of Gwalia more than $190 million.

The administrators claimed Mr Ross-Adjie used a series of off-balance sheet accounts to house
the profits and losses from his gold and foreign exchange trading activities.

According to the report, Mr Ross-Adjie was suspended from all duties by the Sons of Gwalia
board on May 8, 2000, soon after he had told the company in a letter he believed those trading
activities were ‘out of control’.

A reconciliation of the trading accounts revealed Sons of Gwalia was exposed to losses of
$125 million.

‘At the time the directors considered that the extent of the potential losses threatened the
company’s existence,’ the report said. ‘It is noted that no public announcement was made in
respect of the unauthorised trading positions and the potential consequences for the company,
Eardley Ross-Adjie’s suspension by the board or the reasons for it, the trading book losses,
the off-balance sheet monies or the steps taken by the company to remedy the problem caused
by the unauthorised trading.’

The administrators said an independent expert had arrived at the preliminary conclusion that if
the proper accounting treatment of the losses arising from the unauthorised trading had been
applied, Sons of Gwalia would have actually reported a loss for the 2000 financial year rather than
the $83.6 million profit it announced. What’s more, further losses would have followed.

It was the investigation into those trading activities that led the administrators to form the view
that executive chairman Peter Lalor and commercial and legal director Chris Lalor were also
at fault.

According to the report, the list of possible breaches by the Lalors included failing to put in
place effective internal controls over the company’s treasury operations; failing to supervise
those operations; failing to ensure Mr Ross-Adjie abided by the trading limits set by the
board; and failing to inform the board of the manner in which those treasury operations
were being conducted.
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In addition, the administrators claimed the Lalors may have breached the Corporations Law
by failing to keep adequate financial records in the six years to 2003; failed to ensure those
financial reports complied with appropriate accounting standards; failed to meet their continuous
disclosure obligations with the Australian Stock Exchange and failed to understand the nature
of the financial derivative products being traded and the imprudent financial risk associated
with them.

While those claims are prefaced with the term ‘may have’ in the report, they become allegations
in the writs issued against the Lalors. The situation is similar for Mr Ross‑Adjie, Sons of Gwalia
director Tom Lang and auditor Ernst & Young.

When the Lalors left Sons of Gwalia in April last year, it closed a chapter in the company’s
long history.

Unfortunately for them, the Sons of Gwalia administrators have opened up a new chapter.

Source: M. Drummond 2005, ‘How sons of Lalor built, then sank Sons of Gwalia’, The Sydney Morning
Herald, 22 August, accessed May 2010, http://www.smh.com.au/news/business/how-sons-of-lalor-built-
then-sank-sons-of-gwalia/2005/08/21/1124562748347.html.
© The West Australian.
This material is West Australian Newspapers copyright © and must not be reproduced without
permission. WAN © content is supplied for one‑time only use and must not be used outside the agreed
context. WAN material cannot be archived or passed on to any third party under any circumstances.

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Suggested answers
Suggested answers

Question 8.1
When you buy an option, you obtain the right, but not the obligation to buy (call option) or sell
(put option) the underlying instrument. In this case, your exposure is limited to the amount of the
premium paid to the counterparty.

When you sell an option, you are taking up the opposite position. In this case, you have the
obligation to sell (call option) or buy (put option) the underlying instrument if the counterparty
decides to exercise the option. You are therefore taking on a greater risk than if you were to buy
an option (and you receive a premium from the counterparty for this risk).

The pay-off on a sold option is always negative and hence is unlikely to be part of a hedge,
unless it is used as part of a collar arrangement (i.e. to offset the cost of the premium from
the bought option). For this reason, a sold option is not normally an authorised instrument in
a treasury policy. Or, if it is an authorised instrument, there are normally significant restrictions
on the circumstances on when it could be used.

The financial risk management policy may therefore include a section detailing the circumstances
in which sold options may be transacted. This would typically be:
• when combined with a bought option (of equal maturity and principal amount) as part of
a collar hedging strategy that has been approved by the risk management committee; or
• with prior approval from the risk management committee, to cancel a previously purchased
option where hedging is no longer required (i.e. closing out the position).

Having identified the instruments to be used, it also necessary to detail in the policy the
guidelines that must be observed in relation to the use of derivatives, namely:
• the item to be hedged must expose the organisation to movements in interest rates or
exchange rates;
• the instrument must be efficient in reducing the exposures;
• leveraging of transactions is not permitted (i.e. taking positions that the company would
generally not have in its normal course of business);
• hedging transactions (excluding cash investments and money market securities used for
daily cash management purposes) should reflect the financial risk management strategies
approved by the risk management committee; and
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• trading activities that create new or additional exposures are not permitted.
 542 | CONTROLLING RISKS

Question 8.2
Once a level of uncertainty (risk) is identified that is outside the level an organisation is prepared
to tolerate, it is necessary to consider what controls might be best applied to reduce that risk.
While detailed actions may be determined with reference to the causes identified, the risk control
strategies adopted should be consistent with the level of uncertainty of outcome, the ability to
manage the risks and what we judge to be the potential effectiveness of control actions.

Effective controls should reduce the risk from an unacceptable to an acceptable level. For example,
the use of derivatives without appropriate controls would be unacceptable, whereas controls can
be implemented to significantly reduce this risk to an acceptable level.

Question 8.3
It is not enough to implement a technical process to measure and monitor liquidity risk.
The results are meaningless unless they are put into a context that is specific to a particular
organisation. The question the liquidity risk policy has to answer is: How much risk appetite does
the organisation have?

The risk policy should cover three basic aspects:

• nominating how much decision power is delegated to the business managers;
• identifying the actual quantitative limits and the limit structure; and
• identifying the escalation procedures.

A variety of issues needs to be discussed and analysed when creating the appropriate risk policy.
Here are a few key questions to consider:
• How accurate have liquidity forecasts been in the past?
• What have been the sources of sudden liquidity requirements? Are these currently stress
tested and captured in the planning process?
• What level of banking facilities is maintained? What is the cost of these facilities?
• Are new businesses and new products required to run through a review process to gauge
the potential liquidity risk associated? Could this lead to a ‘no go’ decision?
• Will different levels of businesses have tighter or looser controls?
• How rigid or flexible is the limit structure? Are the limits supposed to penalise liquidity users?
How much do liquidity generators benefit? Are buffers in place or are the limits ‘hard’ limits,
close to the existing risk level?
• How is the release control of the models organised? Is there a regular release plan? What are
the criteria to evaluate the integrity of the new models?
• How often are the limits reviewed? What is the process for changing limits? How are limit
violations managed?

These questions highlight the fact that there is no such thing as a standard risk policy.
The framework has to fit the individual organisation and support, and even enhance,
the business.
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Question 8.4
The overriding objectives of a credit policy are to:
• be able to identify and quantify credit exposure in a consistent manner across an organisation;
• ensure that all credit assessments are carried out in a consistent manner and to the same
standards;
• ensure that customers are treated consistently when dealing with different functions—that is,
on similar terms;
• be able to identify group exposures and structures; and
• capture and report the total exposure to all customers in a consistent and timely manner.

Question 8.5
While derivatives are effective instruments to manage interest rate risk, if misused they create
their own risks. Accordingly, it is important that appropriate controls be implemented in the
organisation before using derivatives. These controls are summarised as follows:

1. Is the purpose (strategy) of using the derivative clear?

Unless the purpose for using derivatives is clear, there is a risk that the derivatives will be
misused either accidentally or on purpose.

This can be controlled by clearly setting out in a policy document that has been approved
by the board, the strategy and objective for using certain hedge instruments for the
management of interest rate risk. This policy should cover who can approve the derivative,
what sort of derivative can be used, what percentage of underlying debt should be hedged,
the timeframe of the hedge, the credit limit of the hedge counterparty and how this should
be measured.

2. Can the systems and processes handle the derivative?

The organisation should have appropriate systems and processes to manage the risk
associated with derivatives, given the complexity of accounting for derivatives (determining
fair value of the derivative and observing the formal documentation and effectiveness
requirements of hedge accounting). In this respect the following should be considered:
–– Determine what systems and processes will be used to ensure the derivative is correctly
and promptly captured and valued within the accounting records and whether there are
any formal accounting requirements.
–– Consider the use of a treasury system or whether to outsource the accounting and
valuation to a third party with appropriate expertise.
–– If these functions are to be performed in house, it will be important to have a procedures
manual to help staff to comply with the various obligations.
–– Decide how the reporting to the board/audit committee will be modified to ensure
the board is fully informed on the use of the derivatives and the results of the hedging
program and undertake a regular review of the program to ensure it continues to meet
its objectives.
–– Determine how compliance with the treasury policy will be continuously monitored.
–– Implement reconciliations of all derivative account balances.
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3. Is there appropriate segregation of duties?

A key control in respect of the use of any derivatives is to ensure duties are segregated
between those who transact the derivative and those who record the derivative. This should
be dealt with in the policy document. The back office should be responsible for ensuring
all derivatives are captured in the systems promptly and accurately, have been approved in
accordance with the policy and are supported by an appropriate legally binding contract with
an approved counterparty.

4. Accounting presentation and disclosure?

Given the significant disclosures associated with the use of financial instruments, it will be
important to ensure that derivatives are appropriately disclosed in the financial statements.
This disclosure will need to cover the entity’s objective, policies and processes for managing
the risk, and the method of measuring the fair value of derivatives. Any changes from the
previous reporting period should also be reported.
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 References | 545

References
References

ASX CGC (Australian Securities Exchange Corporate Governance Council) 2014, Corporate
Governance Principles and Recommendations (3rd edn), ASX, Sydney.

ASX (Australian Securities Exchange) Markets Supervision Education and Research Program 2009
Guide for Small-Mid Market Capitalised Companies, ASX, accessed August 2013, http://www.
asxgroup.com.au/media/PDFs/final_presentation_deloitte_crabb.pdf.

Burns, J. & Simer, B. 2013, ‘COSO enhances its Internal Control–Integrated Framework’, Deloitte
Heads Up, vol. 20, no. 17 (10 June).

COSO (Committee of Sponsoring Organizations of the Treadway Commission) 2013, Enterprise

Risk Management—Integrated Framework, American Institute of Certified Practising Accountants,
New York.

US Congress 2002, Sarbanes–Oxley Act (SOX), United States Government, January,

Washington, DC.

Standards Australia/Standards New Zealand 2009, AS/NZS ISO 3100:2009 Risk Management—
Principles and Guidelines, Standards Australia, Sydney/Standards New Zealand, Wellington.

Optional reading
CPA Australia 2005, Understanding and Managing Financial Risk—A Practical Guide for Company
Directors and Business Executives, Revised edn, CPA Australia, Melbourne.

Crouhy, M., Galai, D. & Mark, R. 2001, Risk Management, McGraw Hill, New York.

Deloitte 2009, Risk Intelligent Governance—A Practical Guide for Boards, Deloitte Touche
Tohmatsu, December 2009.

Deloitte 2009, Hedge Strategy—Does Your Policy Shape up?, Deloitte Touche Tohmatsu,
December 2009.

Deloitte 2008, Recognise and Manage Risk—A Guide to Compliance with ASX Principle 7,
Deloitte Touche Tohmatsu, December 2008.
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