By Alaina Roussel
Treasurer, before considering the use of a financial instrument, has to know to what extent it is exposed to risks. Once the degree of exposure is defined, he must anticipate on future interest rates. From this moment on, he that may choose a relevant financial instrument.
To handle these management instruments of FX risk and interest rate risk, the treasurer uses a software specialized in calculating and predicting financial operations risks and able to cover the whole treasurer’s chain, from Front to Back Office via the Middle, and from the creation of the operation to the accounting through the banking communication and the effective cash management. These comprehensive software are commonly called TMS (Treasury Management System) or smart TMS.
Simpler solutions, which are limited to the management of financial operations and associated risks, are also available on the market and can be integrated into an IS already providing cash management and payment factory.
There are two main risks that the treasurer may have to manage:
The subject of interest rate risk management is becoming increasingly critical for treasurers although the volatility of interest rates in Europe has declined considerably because of the recent anti-inflationary monetary policies.
The treasurer has to:
4 variables influence the level of interest rates:
The most functional classification is the distinction between OTC markets (Over-the-Counter) and organized markets and the instruments are intimately linked to markets.
This type of instrument are used to exchange everything and anything on the OTC market.
The interest rate swap is defined by a bilateral contract in which counterparties agree to exchange a fixed rate against a floating rate. When signed, the contract does not involve any flow of funds. This is only at the end of each period that one party pays the interest differential.
The amount of the swap agreement is fictitious and freely negotiated between the participants.
A futures contract is a contract by which one can immediately fix the interest rate on an investment or a loan that will be done later. In this case, an organization and a bank irrevocably decides to perform an operation for an amount, duration or rates, at a deferred date included in the contract.
The treasurer who opt for this contract will guarantee an interest rate for a future period and would ensure the realization of the subsequent operation of investment or borrowing.
Note that the fixing of the interest rate by the bank is essential for the realization of the future operation of investment or borrowing.
The principle of this contract is the same as the previous one, but it differs in the dissociation between the hedge defined by the contract and the future investment or borrowing transaction by the company.
The organization ensures an immediate interest in the amount, currency and a defined period, so that the proposed transaction will intervene only later.
An organization is likeky to be exposed to 3 types of currency risk:
There are several types of exposures to currency risk:
The exporter denominating its foreign debt is exposed to currency risk.
If depreciation of the currency against the local currency, the counter value of its euro-denominated debt will decrease. At maturity thereof, the exporter will receive less euros in foreign currency received on the spot foreign exchange market.
The importer who is having its foreign currency denominated debt is exposed to currency risk. Indeed, in the case of increase of the currency against the local currency, the counter value of its euro debt increase.
At debt maturity , the importer will have to pay more euros to purchase the currency needed to settle it.
A conditional (uncertain) operation is an operation that may or may not fulfill. The probability of occurrence, and thus inclusion in the balance sheet of the company, is of course extremely difficult to quantify. Notwithstanding, the most appropriate instruments to manage exchange risk related to conditional transactions are currency options.
Knowing the fundamental factors is essential to define the evolution of exchange rates. It helps to build medium and long term forecasts about future exchange rates.
These factors are:
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