International Cash Management Chapter 3-1 PDF

# Chapter 3 Treasury Organisation ## Introduction When setting up a treasury department, a company must first draw up rules and guidelines. Treasury tasks must be defined clearly, and the company must decide whether treasury activities should be profit-making, or confined to minimising costs and...

# Chapter 3 Treasury Organisation ## Introduction When setting up a treasury department, a company must first draw up rules and guidelines. Treasury tasks must be defined clearly, and the company must decide whether treasury activities should be profit-making, or confined to minimising costs and optimising revenues arising from cash management activities. Also, the company must determine how the treasury will be organised, including where treasury activities will be carried out and how responsibilities and lines of authority will be allocated. The treasurer must identify the nature and level of the financial risks to which the company is exposed, as well as how they are to be managed. ## The Increased Interest in Treasury Activities More and more companies are now realising the importance of treasury activities. The reasons for this increased emphasis on treasury management include: - An increase in international trading opportunities - Growing complexity of financial markets - Greater emphasis on shareholder value (profit) - Greater emphasis on optimal balance sheet ratios - Increasing awareness of the importance of financial risk management and oversight - Advances in information technology - Introduction of the euro - Decreasing monetary restrictions ### An Increase In International Trading Opportunities Increased participation in global trade bodies like the World Trade Organisation and the expansion of regional trade zones like the European Union, has encouraged many companies to look abroad for new markets and new locations for procurement and production. In the process they have set up new foreign operating companies and acquired control of existing companies in their countries of interest. This globalisation has created more complicated trade flows, including inter-company transactions across borders. Other consequences are a greater exposure to foreign exchange risks, and contact with different tax and regulatory regimes. ### The Growing Complexity of the Financial Markets The deregulation of the capital markets has sparked a tremendous increase in the use of both existing and new investment and financing instruments. Companies must keep abreast of new funding alternatives and carefully assess their advantages and disadvantages, making sure they meet their financing requirements at the lowest cost. ### Greater Emphasis on Shareholder Value (Profit) In recent years companies have been under increased pressure to create value for shareholders. This has led to ambitious profit targets and a growing need to limit any losses on financial positions. Most treasury departments are now expected to neutralise the effects of adverse interest rate and foreign exchange movements, while at the same time limiting the costs of treasury activities and optimising income earned on cash surpluses. The goal of outperforming 'the market' is now the rule rather than the exception. ### Greater Emphasis On Optimal Balance Sheet Ratios Banks and investors are also looking ever more critically at the composition of the company's balance sheet. Treasurers are expected to create and maintain optimal balance sheet ratios, which they impact by adjusting key drivers of the debt/equity ratio and the long-term debt/short-term debt ratio, and by pursuing active working capital management. ### Increasing Awareness Of The Importance Of Financial Risk Management Companies are increasingly aware of the financial risks they face, resulting from new regulatory pressures and new emphases in corporate governance. Increasing risk awareness is the main reason that most companies, despite their aim of creating shareholder value, do not go so far as to organise treasury departments as profit centres. Treasurers who operate their departments as profit centres risk taking unwise gambles with the corporate balance sheet in an effort to drive treasury revenues. ## Treasury Tasks The first step in mapping out the treasury policy is to distinguish the treasury tasks from those of the other financial functions. The treasury function spans several different fields. These are briefly summarised below: | Tasks | |-----------------------------------| | Cash Management | | Financial Risk Management | | Corporate Finance | | Other Functions | | Investor Relations | | Bank Relations | | Insurance | | Tax | | Pension Fund | | | **Figure 1: The Fields of the Treasury Function** A company must make sure that the scope of these tasks is properly defined. This is particularly the case in the fields of corporate finance and insurance. In order to create an unambiguous segregation of tasks and responsibilities, the company must clearly identify the tasks that do and do not fit within the treasurer's remit. ### 2.1 Cash Management Cash management is defined here as the management of cash balances and funds flows. In this context, the cash manager aims to manage the cash position, keeping the costs arising from cash flows as low as possible, while minimising interest costs and maximizing interest income. The following sub-tasks are distinguished in this context: - Liquidity management: cash balances management and funds management - Cash flow management - Working capital management * **Liquidity Management:** Liquidity management can be divided into cash balances management and funds management. Cash balances management refers to the day-to-day management of the company's current accounts. Every day the cash manager seeks to control the company's cash balances in such a manner that the interest result on these balances is optimised. * **Funds Management:** Funds management refers to the management of the company's cash positions. In contrast with cash balances management, this involves cash positions that exist for a longer period of time (for instance longer than a week). * **Cash Flow Management:** Organisation of commercial payments is another important cash management task. Cash flow management aims to reduce the number of payments, cutting the transfer costs per payment and effectively managing the outgoing payments while accelerating the incoming payments. Another task for the cash manager is to support accounts payable and accounts receivable administration. * **Working Capital Management:** In some companies, working capital management is also one of the cash manager's tasks. Working capital is the difference between current assets (cash and quickly realisable assets, including investments) and current liabilities (liabilities that are repayable within one year). The size and composition of working capital largely determines the company's liquidity. Working capital management breaks down into: - Accounts receivable management - Accounts payable management - Stock management Important considerations for the cash manager are: How quickly do customers pay their bills? How long do stocks remain on the balance sheet? How long can the company wait before paying its suppliers? Some of these activities can be delegated to other specialists or departments. A separate department can, for instance, be set up under the direction of a credit manager to manage accounts payable. Stock management is usually entrusted to the production department. However, the cash manager will always keep close track of all the variables that influence cash flows. This is natural considering the company's cash position depends largely on the quality of its working capital management. ### 2.2 Financial Risk Management Financial risk management is the activity dedicated to controlling the interest rate and foreign exchange risks of a company. * **Foreign Exchange Risk Management:** Foreign exchange risk is the risk that fluctuating foreign exchange rates will have a negative impact on the company's results or value. We distinguish three types of foreign exchange risk: - Transaction risk - Translation risk - Economic risk * **Transaction Risk:** Transaction risk is the risk that the company's profit is eroded by exchange rate movements that negatively affect purchasing costs or selling prices. This risk arises when imports or exports are settled in foreign currency. Virtually all international companies are exposed to transaction risk. * **Translation Risk:** Translation risk is the risk that foreign exchange fluctuations have a direct impact on the company's asset value. A company is exposed to translation risk when it has assets denominated in one currency without offsetting liabilities in that same currency. * **Economic Risk:** Economic risk is the risk that a country where production takes place becomes expensive compared to others, so causing a deterioration in the company's competitiveness. Possible causes are higher labour costs or a structurally strong currency in the country of production. The following tasks can be distinguished in relation to foreign exchange risks: - Determining the foreign exchange strategy - Monitoring the foreign exchange positions - Deploying various instruments to reduce and/or hedge the positions * **Interest Rate Management:** At it's highest level, interest rate risk is the risk that interest rate movements will have a negative impact on operating results. This risk arises when future interest flows from cash positions are not fixed. Interest rate risk may also arise from a change in interest rates that impacts the value of assets or liabilities, or the value of a company's financial contracts. Most companies are sensitive to fluctuations in interest rates. The treasurer's task is to reduce the negative impact of these fluctuations. Money market and capital market rates change may change every moment and these fluctuations must be expertly handled to achieve effective interest rate risk management. The treasurer is expected to: - Develop an interest rate vision - Monitor the company's interest rate positions - Conclude transactions in the money and derivatives markets ### 2.3 Corporate Finance The corporate finance function has the following roles: - Financing policy - Optimising the balance sheet structure (asset and liability management) - Producing a financing plan The treasurer first determines the period during which financing is needed as well as the required currency. Next, he explores the available financing methods, such as bank credits or alternative instruments like bonds or commercial paper. He will generally try to match the term and currency of the finance with the company's assets. In other words, he will seek to finance fixed assets with long-term loans, and current assets with short-term loans. Matching the company's liabilities with its assets is called asset and liability management. ### 2.4 Investor Relations, Bank Relations, and Other Activities * **Bank Relations:** Bank relations involve the exchange of information with banks as well as the direct negotiations on terms and conditions. Bank relations are commonly carried out by the treasury department. * **Investor Relations:** Investor relations has a broader scope than bank relations and involves the supply of information to all (potential) suppliers of funds. Investor relations, therefore, are of great strategic importance. These activities are often carried out by a board level director, but the corporate treasurer may have an advisory role. The most important aim of investor relations is to obtain and retain access to the financial markets. From a financing point of view, the company must have strong contacts in the financial world. A well-known example of an investor relations activity is the organisation of roadshows for share or bond issues. Apart from the tasks already mentioned, many treasury departments also perform tax insurance and pensions activities. Where the treasurer combines financing expertise with an in-depth knowledge of tax affairs, he can devise a highly tax-efficient financing structure for the MNC. ## The Mission of the Treasury Department The company must give the treasury department a mission. In general terms, the mission statement can be described as follows: to make a contribution to the financial position of the company, so that sufficient cash is always available and the interest rate and foreign exchange risks are always effectively managed. One vital question is the strategy for handling interest rate and foreign exchange risks. These risks can be controlled in various ways: - Defensive: The complete coverage (or hedging) of interest rate and foreign exchange positions - Offensive: The selective coverage (or hedging) of interest rate and foreign exchange positions - Aggressive: The deliberate creation of interest rate and foreign exchange positions When the company chooses the third strategy, one of the treasury's objectives is to make a profit on the positions taken. These positions can be unrelated to the operating activities. Most companies, however, limit the scope of their treasury activities to the (partial) hedging of positions. When the company opts for an offensive or an aggressive treasury strategy, it must formulate interest rate and currency views as a framework for decision-making. These are often devised by a treasury steering committee, where the financial director, treasurer and usually the cash manager play key roles. These views guide the company's transactions in the foreign exchange and money markets. ## The Organisation of the Treasury Department A third important decision-making area concerns the organisation of the treasury department. The following aspects play a role here: - The degree of centralisation of the treasury activities - The geographical organisation of the treasury function - Allocation or costs and revenue activities - The segregation of tasks - The determination of limits - The management of the risks ### 4.1 The Degree of Centralisation of the Treasury Activities The first question is: Where is the most beneficial location for treasury activities to be carried out? Should all operating companies be responsible for their own treasury activities or are these treasury activities to be carried out centrally? To varying degrees, most international companies have centralised their treasury and cash management activities. MNCs generally strive to centralise cash management as far as possible. When companies first venture into international markets, they often initially opt for a decentralised structure with foreign business units enjoying considerable autonomy. In this phase, the cash management activities are usually also decentralised. Local cash managers carry full responsibility for managing their own liquidity and currency positions. All transactions are settled with local banks. Over time, MNCs realise significant efficiencies and financial benefits can be achieved by centralising treasury activities. The following phases in this process can be distinguished: - Central interest rate, currency risk management, and central management of large liquidity positions - Central interest rate, currency risk management, and cash balance and liquidity management - Fully centralised treasury **Figure 2: Different Phases in the Centralisation of Cash and Treasury Management** The figure below indicates which activities are centralised in each phase, and which activities are still carried out at the individual business units. * **Decentralisation of Cash and Treasury Management:** Multiple local bank relations; Local interest and currency management; Local liquidity management; Local cash flow management; Local AR/AC management. * **Centralisation of Interest and Currency Management; Central Liquidity Management/Large Exposures; Netting:** Multiple local bank relations; Local liquidity management; Local cash flow management; Local AR/AC management; *** **Central Treasury/In-house Bank:** * Centralisation of Interest and Currency Management; Netting; Central Liquidity Management; Central AR/AC Management; * Centralisation of Liquidity Management: Local cash flow management; Local AR/AC Management; **Central Cash Flow Management:** * Centralisation of Interest and Currency Management; Netting; Central Liquidity Management; Central AR/AC Management; * Centralisation of Liquidity Management; Fully centralised cash and treasury management; Central systems ### 4.1.1 Step 1: Centralisation of Interest Rate and Currency Risk Management The first step towards the centralisation of treasury activities involves the creation of a central treasury department, which carries out a number of tasks for the group. In the first stage, treasury activities will be confined to the following tasks: - Interest rate risk management - Currency risk management - Management of large liquidity positions The central treasury department can take various shapes. Two of the most common are discussed below. These are: multi currency centres and in-house banks. * **Multi Currency Centres:** Over the past decades many US companies with European activities have set up 'multi currency centres' in Europe. Multi currency centres are treasury units that open central accounts in all relevant European currencies. These accounts are then used for the central collection of all balances from the European business units. Transfers from the business units to the central treasury must be sufficient-ly frequent to avoid the occurrence of large decentralised balances (and related currency risks). The great advantage of multi-currency centres is that all currency transactions are executed centrally for all European business units. Credit and debit balances can thus be set off against each other. In addition, multi currency centres can generally obtain more favourable rates from banks than individual business units could acting independently. The arrival of the euro reduced the tasks of multi currency centres, but they can still add value. After all, many currencies continue to exist alongside the euro in Europe. In addition, the euro has opened up more opportunities for cash balances management. Multi-currency centres are, therefore, increasingly focusing on the creation of euro cash pools. In this phase, each operating company conducts most of its own cash management tasks. The local cash managers manage their own accounts, and conclude some of the required money market and currency transactions. Debtor and creditor management, as well as the related payments, also take place at the operating companies. A central treasury can let the business units participate in arrangements made with the banks concerning e.g.: - Payment services - Credit facilities - Credit insurance - Electronic banking * **The In-house bank:** Some central treasury departments process transactions in the name of, and for, the accounts of the business units. In this case, they act as an agent for the business units. Central treasury departments first consolidate all the business units' positions and then cover the group positions. Here, the central treasury department acts as the counterparty of the bank, and concludes internal transactions with the individual business units. Because the central treasury deals with the bank on behalf of the business units, and provides the business units with services that were formerly supplied by a bank, it is referred to as the in-house bank. To fulfil its intermediary function, the in-house bank needs an internal system of current accounts and a central settlement administration. The scope of operations undertaken by an in-house bank differs from company to company. Some companies with a central treasury or in-house bank allow their operating companies to use the services of an external bank. In this case, however, they are still generally required to ask the central treasury for a price quotation. At other companies, however, the operating companies are obliged to use the services of the in-house bank. All transactions above a certain size must then be concluded at the central treasury. ### 4.1.2 Step 2: Centralisation of Liquidity Management The second step towards fully centralised cash management is the centralisation of liquidity management. In the first phase, the various business units maintained accounts at local banks. These accounts did not usually form part of a cash pool. The local cash managers were responsible for managing these local accounts as well as for depositing liquidity surpluses and replenishing liquidity deficits in the money market. As we saw, in this phase, the local cash managers are usually already required to transfer very large positions to the central treasury. The centralisation of liquidity management often takes place in steps. Three successive steps that the central treasurer can make to arrive at central liquidity management are: - Creation of local cash pools - Creation of an international cash pool - Replacement of accounts at local banks with accounts at the principal bank ### 4.1.3 Step 3: Centralisation of Transaction Processing The final step towards fully centralised cash management involves the centralisation of all incoming and outgoing payments. In some cases, documentary payments are also centralised. Centralising the transaction processing system can be time-consuming, but offers many advantages such as: more accurate cash flow forecasts and lower transaction costs. Before the company centralises the processing of debtor and creditor payments, all business units manage their own payments and the local cash managers are responsible for the resulting cash flows. The characteristics of decentralised processing of debtor and creditor payments are: - Use of many different banks - Use of different debtor and creditor systems - Use of several electronic banking systems - Local management of payments The centralisation of the transaction processing system can take place in the following phases: - Centralisation of payments; payment and collection factory - Centralisation of the entire debtor and creditor management; shared service centres - Outsourcing of the entire debtor and creditor management * **Payment and Collection Factories:** The first step towards the centralisation of debtor and creditor management concerns the centralisation of all incoming and outgoing payments relating to these debtors and creditors. To this end, the company sets up a new central business unit: the payment and collection factory. The local business units continue to conduct their own debtor and creditor administration, but all transfers are carried out by the payment and collection factory. * **Shared Service Centres:** Some companies take the centralisation of services a step further. They opt to centralise their entire debtor and creditor management. The business units are relieved of this administrative burden and can concentrate completely on their core activities. The unit where the central debtor and creditor management takes place is called a shared service centre (SSC). Such an SSC can also carry out other non-core tasks, such as salary administration and back-office activities. The degree to which the financial functions are transferred to an SSC differs from company to company. Sometimes the operating companies themselves prefer to continue carrying out certain parts of the transaction processing. They may, for instance, want to receive invoices directly from suppliers and then forward these to the payments and collection factory. Sometimes the collection of outstanding debtor payments can be more conveniently arranged at local level. * **Outsourcing:** Companies can realise substantial cost savings by centralising certain cash management activities. At a certain point, however, the opportunities for cost savings through internal centralisation will be exhausted. Then, further cost reductions can only be achieved by outsourcing a number of activities. Various market parties currently offer transaction processing services. These include treasury consultancy agencies, accountancy firms and banks. A growing number of medium-sized companies are tending to outsource parts of their cash management activities in order to concentrate on their core activities. Though outsourcing in specific situations may significantly reduce overhead costs, many companies are reluctant to embrace this option. This is understandable, particularly if they have gone to great expense and effort to set up their own shared service centre. Also, many companies feel that direct management of cash flowing through the company provides a means to keeping a finger on the pulse of the company. A change in cash flows can be an early indicator of future problems. ### 4.1.4 Advantages and Disadvantages of Centralisation The advantages of centralisation are: - Concentration of knowledge and experience, leading to improved results with fewer people and reduced risk of error - Matching of financial positions and cash flows (where applicable), leading to a better margin and lower costs - Central purchasing of financial services, leading to larger volumes and more competitive rates - Tighter control to ensure implementation is in line with treasury policy The disadvantages of centralisation are: - Reduction of local know-how - Local opposition to the relinquishment of powers - Reduced attention at operating companies for centralised cash management tasks - Complex management information system (MIS) flows and demands on enterprise resource planning (ERP) systems On balance, the advantages of centralisation often outweigh the disadvantages. ### 4.2 Geographical Organisation of the Treasury Function MNCs with worldwide activities often open regional treasury centres in three key time zones: - Asian time zone - European time zone - American time zone These regional treasury centres perform the treasury operations of all subsidiaries in the relevant time zone. Though the regional treasury centres are frequently located in a different country from the holding company, they form a critical functional part of this holding company. Wherever possible, the regional treasury centres are located in a country with a friendly monetary and investment climate. In Europe, this includes cities such as Brussels, Amsterdam, Dublin, Zurich and London. These locations are called 'financial centres'. The diagram below illustrates the organisational structure of a European MNC with a regional treasury centre. **Figure 3: A Holding Structure with a European Treasury Centre** * **CFO** * **Corporate Treasurer** * **Global Treasury Centre** * **Regional Treasury Centre Europe** _American Time Zone_ * **Regional Treasury Centre Europe** _European Time Zone_ * **Regional Treasury Centre Asia** _Asian Time Zone_ ### 4.3 Allocation of Costs and Revenues of Treasury Activities Where all or some of the treasury tasks are centralised, it is necessary to determine who bears the risks of the treasury activities, and how the resulting costs and revenues are distributed across the central treasury and the operating companies. There are two possibilities, depending on whether the central treasury is a profit centre or a cost centre. **Profit Centre:** If the treasury is a profit centre, it has its own profit target. To comply with this target, the treasury is allowed to take financial positions that are not related to the positions of the company's operating businesses. Transfer pricing policies will help determine where treasury mark-ups/mark-downs can be taken. This, of course, must be done with clear advice form tax departments. **Cost Centre:** If the treasury department has no profit target of its own, it is called a cost centre. In some cases, the treasury is obliged to hedge immediately all positions arising from a company's business (defensive strategy). In other cases, the treasury department is allowed to postpone the necessary hedge transaction, or to leave a part of the position open (offensive strategy). In the latter case, the treasury department is sometimes referred to as service centre. ### 4.4 Segregation of Tasks Once the tasks of the treasury department have been clearly established, the various functions must be accurately defined within the treasury department. The day-to-day work of the treasury department consists of managing the cash balances, determining the positions, concluding financial contracts. The following functions are undertaken in the performance of these activities: - Front-office functions: responsible for concluding treasury transactions - Back-office functions - Deal check - Deal authorisation - Deal settlement - Confirmation - Contract administration - Provision of position information - Monitoring of the maturity calendar (items falling due) - Financial accounting functions: responsible for processing the transactions in the group accounts For control purposes, tasks belonging to these functions must be separated as far as possible. One of the greatest organisational risk factors is the failure to segregate clearly responsibilities, powers, and tasks. Unambiguous answers must, therefore, be given to the questions: Who is, and who is not, allowed to do what?; Who must do what?; and, finally, Who controls, approves, and reviews? The most important segregation of duties is between front and back office activities. The officer concluding a deal must never actually control resulting payment flows. The diagram below illustrates the segregation of functions within the treasury department. **Figure 4: Workflow of a Treasury Deal** * **Input Deal** * **Front Office:** Check Deal, Authorise Deal, Settle Deal, Confirm Deal * **Back Office:** Input in Ledger * **Accounting Department** Sometimes, companies set up a specific department between the front-office and the back-office, called the mid-office. The mid-office assumes some of the other departments' tasks, with the drawing up of position reports, performance reports and risk reports usually its main responsibility. ### 4.5 Treasury Control The treasury faces two main types of risk: operational risk and position risk. Operational risks arise from shortcomings within the organisation itself. Examples are procedural weaknesses, system errors, human error and fraudulent actions. Position risks are attributable to the existence of 'open positions' that expose the company to foreign exchange risk. The company can take several steps to minimise these risks. #### 4.5.1 Limits A limit system must be set up to facilitate risk management. The system indicates exactly what transactions are permitted, with which counterparties and up to what amount. Exceptional approval must be obtained for transactions outside these limits. A limits system defines the following aspects: - (Types of) instrument - (Types of) counterparty - Countries and currencies - Officers, groups and/or departments **Instruments** Most companies set restrictions on the number of products that the treasurer may use to cover positions. The use of financial derivatives, for instance, is forbidden at many companies. Derivatives are financial products whose value is derived from other financial products. **Counterparties** The company must also determine the parties with which the treasury is allowed to do business. A total limit is frequently set per counterparty. This means that the total amount of all transactions with a particular counterparty must remain within the set limit. **Countries and Currencies** Very often the trading activities of the treasury department are subject to strict limits in terms of currencies and countries. Apart from the home country's currency, trading will usually be restricted to the currencies of the OECD countries (i.e. the most industrialised countries) and those of the main trading partners outside the OECD area. **Officers and Departments** The organisation must define the type of transactions that each officer is allowed to conclude, as well as the maximum transaction sizes. These are called the 'transaction limits'. The company must also establish for each staff member (including the treasurer), whether and to what amount he is authorised to make or approve external transactions, such as outgoing payment transfers, foreign exchange transactions, money market transactions or derivative transactions. All transactions should require a separate initiator and approver. #### 4.5.2 Internal and Position Control Treasury activities give rise to two types of risks. Correspondingly, a company has to set up to two types of controls: internal control and position control. **Internal Control:** Internal control is the control over the operational risks of the treasury, and is carried out by the internal auditor or the controller. Internal control includes retrospective checks to ensure that contracts have been concluded and settled in compliance with the adopted procedures, guidelines and limits. The internal auditor checks the following points in this context: - Power of attorney (who is allowed to sign and up to what amount) - Authorisation (who must approve what in advance) - Adherence to limits - Compliance with procedures **Position Control:** Position control is aimed at monitoring the value of outstanding contracts. The treasurer is responsible for this. In this connection, the treasurer will calculate the short- and long-term effects of all open positions, both individually and in conjunction with each other. To this end, the treasurer will need frequent - at minimum daily - reports on all open positions to permit timely corrective action if positions become unbalanced. In emergencies, multiple 'intra-day' updates will be necessary. ## Treasury Systems An accurate information system is an absolute must for the modern treasurer. Apart from an electronic banking system provided by the bank, the treasurer should have a treasury information system which captures all the treasury flows. The most important functionalities of such a system are: - Deal capture - Reporting - Decision support In order to present the right information, a treasury system needs to import information from other systems, such as an electronic banking system and Accounts Payable/Accounts Receivable systems, EXP and payroll, as well as information from data vendors, such as Reuters and Bloomberg. Most systems are also directly linked with the ledger. The reporting format of the treasury system should, therefore, be compatible with the general accounting standards of the company. The diagram below shows the most important input, functionalities and output of a treasury system. **Figure 5: Input, Functionalities and Output of a Treasury System** * **Banks:** EB-system * **AR/AP System** * **Dealer Entry** * **Data Vendor** * **Corporate Accounting & Spreadsheets** * **Forecast/Cash Management/Netting:** Deal capture, Confirmation matching * **Risk Management** * **Reporting:** Daily/Weekly/management ### 5.1 Deal Capture In the modern trading environment, most deals are entered directly into a treasury system by the traders - the actual execution remains subject to back-office authorisation. All the limits and the selected counterparties are captured in this module to avoid unnecessary risk such as fraud. ### 5.2 Reporting A treasury system may be used to measure the result of all treasury management activities. Periodically, the system should provide information on interest income and foreign exchange results. Also, the revenues of deposits and other financial investments and the costs of funding, may be evaluated and compared with market average to determine whether the treasurer has performed at market level. This routine may also be applied to assess the effectiveness of foreign exchange transactions. The output of treasury systems also includes key management information reports on current and future liquidity positions, and interest and currency positions. ### 5.3 Decision Support: Risk Management In most MNCs, treasurers play key roles in the corporate risk management process. Treasurers' experience with the management of counterparty, currency and interest risk, as well as their expertise of valuation and risk measurement techniques, make them well-equipped for this job. As risk management becomes more and more important for the treasurer, a treasury system needs to assist in valuing open interest rate and currency positions. The most important risks measurement concepts are: - Duration - Value-at-Risk - Stress testing * **Duration:** The duration allows us to express the interest rate sensitivity of, for instance, a loan portfolio. The duration is defined as the percentage change in market value as a result of a small change in interest rates. With duration analysis we can calculate the fall in a portfolio's value given a 1% rise in interest rates. For completeness sake, it must be remarked that the duration is approximately equal to a kind of a weighted tenure of the portfolio. In professional trading, interest rate movements are expressed in basis points (1 basis point = 0.01%). The fall in a portfolio's value due to an interest rate increase of 1 basis point is called the 'Basis Point Value' (BPV). * **Value-at-Risk (VAR):** A method that can be used to measure the risks of all kinds of portfolios is Value-at-Risk analysis. With this method, the risk of a position or portfolio is shown in one single figure. The VaR technique is based on the calculation of probability and indicates a loss value that, with a certain degree of probability, will not be exceeded. This loss value is called the Value-at-Risk of the portfolio. The VaR method assumes a model where, notably, the volatilities of the market variables, i.e. the risk parameters, are the main determinants. The volatilities of the risk parameters are used to calculate the extent to which the market value of a portfolio will change relative to the current market value. The VaR model thus gives possible results of changes in the value of the current portfolio. To calculate the Value at Risk of a loan portfolio, the assumed change of the market interest rate is multiplied by the duration. But which of these possible results is the Value at Risk, 'the possible loss?' To answer this question, all possible results of the model are ordered, starting with the largest possible losses and progressing via declining losses and growing profits to the largest profits. As will be clear, because the VaR is a risk analysis tool, the VaR method focuses exclusively on the possible losses. This, after all, is where the risk lies. Next, a line is drawn at, say, 95% of the observations. We can thus identify the loss value which is exceeded in only 5% of the cases. * **VaR Technique Example:** A company has a loan portfolio of USD 3 billion with a duration of 4,8. With 95% probability the maximum change in interest rate is 20 basis points. The Value at Risk of the loan portfolio is: USD 3 bn x 4.8 x 0.20% = USD 28.8 mio. The VaR technique cannot only be used to calculate the negative change in market value. It can also be used to calculate a negative change in interest income or in credit loss. However, the concept is the same. VaR gives a good indication of the possible losses under regular market conditions; that is VaR gives the loss figure that will not be exceeded in 95% of the cases. However, no indication is given what happens in one of the 5% of the cases left: How much loss may occur then? * **Stress Testing:** In normal circumstances, the VaR is a good instrument for measuring the risk of a portfolio. As we saw, however, the method fails in extreme situations. For this reason, an additional method that provides more information on risks run in extreme market conditions is necessary. This additional method is called 'stress testing.' Stress testing is a generic title for a range of techniques. The basic concept of stress testing is the analysis of the risks a portfolio runs under conditions of extreme price or rate movements. Stress testing examines whether the company could survive under conditions of a market breakdown. Most commonly, stress tests are carried out as scenario analyses. The treasurer has to set up certain assumptions on possible extreme market conditions. The assumed changes in market conditions should, however, not be too small. If this were the case, stress tests would not distinguish themselves sufficiently from regular VaR analyses. Conversely, the test parameters should not be too large, making the chosen scenario improbable and unbelievable. In other words, the treasurer has to set up credible worst case scenarios that the board of directors will take seriously.