Treasury Management Thesis

Sdertrns hgskola Fretagsekonomiska enheten Bachelor Thesis in Finance

Spring 2001

Treasury Management- The case of CGE&Y -

Authors Mats Clarhll Robert Lillerud Advisor Ph.D. of Finance Curt Scheutz

Clarhll & Lillerud

Treasury Management - the case of CGE&Y

AbstractWe have in our thesis empirically investigated if the theory of interest rate parity holds in practice in the Nordic. We did this to see if there is any economic incitement for Cap Gemini Ernst & Youngs Nordic region to transfer and exchange capital between the Nordic countries for investment purposes. We have also looked into Cap Gemini Ernst & Youngs Nordic regions banking situation on a day-to-day basis. We extended the investigation to contain this part as well because we saw drawbacks and problems with the new bank structure and Finance Center that the company was about to implement for the Nordic region. We have through experimental calculations and qualitative interviews found empirical evidence supporting that the theory of interest rate parity holds in practice within the bounds of transaction costs. Therefore, we concluded that there is no economic incitement for Cap Gemini Ernst & Youngs Nordic region to try to attain a higher rate of return through transferring and exchanging capital between the Nordic countries. We also concluded that Cap Gemini Ernst & Youngs Nordic region ought to continuously seek improvements and better conditions in its bank agreements. We found that there are alternatives on the market, which would fit Cap Gemini Ernst & Youngs Nordic region well and could help rationalize its banking situation.

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AcknowledgementsWe would like to thank the following, our advisor Curt Schuetz for all his support and patience. Anneli Petersson at Cap Gemini Ernst & Young with help on company specific matters and always taking time for us. Anders Haller for letting us visit Ericsson Treasury Services and for an amazing half-day! Jan Torberger and Margaretha Bussler at SAS for giving us their time and help. Roger Bydler at Cap Gemini Ernst & Young for introducing us into the company. We would also like to thank Office Borlnge for lending us a Lap Top during the ten weeks we worked with this thesis. Last but not least we would like to thank our nearest and dearest for positive support and help throughout the thesis. That is; Elin, Margareta and Christer, Eva and Lars. Thanks!

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Contents1 INTRODUCTION ....................................................................................................................................... 6 1.1 THESIS OUTLINE ........................................................................................................................................ 6 1.2 BACKGROUND ........................................................................................................................................... 6 1.2.1 The company CGE&Y ..................................................................................................................... 6 1.2.2 The bank situation in the Nordic region of CGE&Y ....................................................................... 71.2.2.1 1.2.2.2 Transfer deadlines..................................................................................................................................... 10 Hedging foreign payments and receivables .............................................................................................. 11

1.2.3 CGE&Ys risk policy..................................................................................................................... 11 1.3 DEFINITIONS ............................................................................................................................................ 11 1.3.1 Definition of Cash Management.................................................................................................... 11 1.3.2 Definition of Treasury Management ............................................................................................. 12 1.3.3 Definition of excess cash ............................................................................................................... 13 1.4 PROBLEM ................................................................................................................................................. 13 1.4.1 Posing of the problem ................................................................................................................... 13 1.5 PURPOSE .................................................................................................................................................. 13 1.6 LIMITATIONS ........................................................................................................................................... 14 2 METHOD................................................................................................................................................... 15 2.1 2.2 2.3 2.4 3 VALIDITY ................................................................................................................................................ 16 RELIABILITY ............................................................................................................................................ 16 THE INTERVIEWS ..................................................................................................................................... 17 THE EXPERIMENTAL CALCULATIONS ....................................................................................................... 18

THEORY.................................................................................................................................................... 20 3.1 THEORETICAL FRAME OF REFERENCE ...................................................................................................... 20 3.1.1 The law of one price ...................................................................................................................... 203.1.1.1 3.1.1.2 3.1.1.3 3.1.1.4 Interest rate parity ..................................................................................................................................... 21 The international Fisher relation............................................................................................................... 21 Relative purchasing power parity ............................................................................................................. 22 Unbiased forward expectations................................................................................................................. 22 Which way should one go?....................................................................................................................... 23 Covered interest arbitrage in practice ....................................................................................................... 23 Currency risk management ....................................................................................................................... 24

3.1.2 3.1.3 3.2 3.3 3.4 4

Covered interest arbitrage ............................................................................................................ 22 Financial risk policy management ................................................................................................ 23

3.1.2.1 3.1.2.2 3.1.3.1

PREVIOUS RESEARCH ............................................................................................................................... 24 THE MODIFIED EXPERIMENTAL CALCULATION MODEL............................................................................. 27 THE 11 OCLOCK RULE ............................................................................................................................ 29

EMPIRICAL INVESTIGATION AND RESULTS................................................................................ 30 4.1 INVESTMENT ALTERNATIVES FOR CGE&Y ............................................................................................. 30 4.2 EXPERIMENTAL CALCULATIONS- EMPIRICAL DEMONSTRATION OF INTEREST RATE ARBITRAGE .............. 31 4.2.1 Investments for one months time with SHBs figures .................................................................... 31 4.2.2 Investments for three months time with SHBs figures.................................................................. 32 4.2.3 Investments for one month time with SEBs figures ...................................................................... 32 4.2.4 Investments for three months time with SEBs figures .................................................................. 33 4.2.5 Investment for one month time, using the most favorable figures from both banks ...................... 33 4.2.6 Investment for three months time, using the most favorable figures from both banks .................. 33 4.2.7 Investment for one months time in Sweden, using the most favorable figures from both banks.... 34 4.3 CORRELATION BETWEEN THE NORDIC CURRENCIES ................................................................................ 34 4.4 THE OVER-NIGHT INVESTMENT SITUATION FOR CGE&Y ........................................................................ 35 4.4.1 Investigation of the 11 oclock rule ............................................................................................... 35 4.4.2 SASs interest rate netting through SEB and results from the interview ....................................... 37 4.4.3 Results from the interview at Ericsson Treasury Services............................................................. 38 4.4.4 SEB as a bank alternative ............................................................................................................. 38 4.4.5 On-line dealing.............................................................................................................................. 39

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ANALYSIS AND CONCLUSIONS ......................................................................................................... 40 5.1 GENERAL ANALYSIS AND CONCLUSIONS.................................................................................................. 40 5.1.1 Capital market equilibrium ........................................................................................................... 40 5.1.2 The risk policy ............................................................................................................................... 41 5.1.3 The Finance Center....................................................................................................................... 42 5.1.4 Investment alternatives.................................................................................................................. 43 5.2 ANALYSIS AND CONCLUSIONS ON THE LONG-TERM, ONE TO THREE MONTHS .......................................... 43 5.2.1 The experimental calculations....................................................................................................... 43 5.3 SHORT-TERM, THE OVER-NIGHT INVESTMENT SITUATION ....................................................................... 44 5.3.1 The 11 oclock rule........................................................................................................................ 44 5.3.2 Make the investing process more effective .................................................................................... 45 5.3.3 Drawbacks with the SHB agreement and comparison to the SEB alternative .............................. 46 5.3.4 Advantages/disadvantages with interest rate netting .................................................................... 46 5.4 RECOMMENDATIONS FOR CGE&Y.......................................................................................................... 47 5.5 CRITICAL REVIEW .................................................................................................................................... 48 5.6 SUGGESTIONS FOR FURTHER RESEARCH .................................................................................................. 49

List of references.50 Appendix A Glossary .53 Appendix B Interview with SAS Cash- and Treasury Management Department...58 Appendix C Interview with Ericsson Treasury Services.62 Appendix D Original questions to the interviews in Swedish.64 Appendix E Original translated questions to the interviews...65 Appendix F Original instructions in Swedish to the calculation experiment..66 Appendix G Original translated instructions to the experimental calculation....67

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1 I n t ro d u c t i o nThe Nordic branch of the French IT & Management consulting company Cap Gemini Ernst & Young, from here on referred to as CGE&Y is about to develop and implement a new treasury function. This kind of development and implementations are often associated with certain problems and questions. The incentive to investigate the treasury function on CGE&Y was partially that the subject is interesting and that we had the ambition to sort out parts of, or any of, these problems and questions. In contrast to accounting, auditing and financial management treasury management is a relatively new function. In general business life treasury management is still a growing phenomenon. Specific for CGE&Y is that the company has not, up until today, used the treasury function in a very extensive manner. CGE&Ys new treasury function will be an integrated and centralized finance function common for all the branches in the Nordic region. The thesis is to present some guidelines how CGE&Y are to invest excess cash on a day-to-day basis and for a period of one to three months. 1.1 Thesis outline

The thesis is divided into five parts. To start with we will describe CGE&Ys current financial situation in the Nordic region out of a Cash- and Treasury Management perspective. The first part continues with a few definitions that are quite essential for the thesis followed by stating the problem, purpose, and limitations. The thesis will then move on to the method part where we will describe how this thesis progressed from the beginning until the end. The method describes our perspective in this thesis and how the investigations and experiments have been conducted. In part three we get acquainted with the theories needed in order to conduct our investigation. These are the underlying theories that we rely on in our analysis and conclusions Thereafter we present the investigations including the experimental calculations and state the results found. The fifth and last part consists of the analysis and conclusions that is complemented by recommendations for CGE&Y in specific. The thesis is completed with suggestions for further research. In the appendix there is a glossary for terms and names of various instruments used throughout the thesis. 1.2 1.2.1 Background The company CGE&Y

In May 2000 the French IT and management consulting company Cap Gemini merged with Ernst & Youngs business line Management Consulting. The main purpose was for Cap Gemini to use Ernst & Youngs well-known name in the USA and thereby gain market shares in the management-consulting segment quicker and more easily. The new company Cap Gemini Ernst & Young was merged and fully operational in January 2001. The company is the worlds fifth largest company within the IT and Management consulting segment and operate globally in 31 countries. The main services that it provides are corporate strategies, system development and outsourcing on the global market. Its aim is to help both dot com companies and traditional companies to be more effective in the new economy. Year 2000 the group had a revenue of 6 931 million EUR and the expected revenues for year 2001 is 6

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calculated to be 9 600 million EUR. The CGE&Y stock is traded at the Paris Stock Exchange. Of the companys 59 000 employees, around 4 860 are employed in the Nordic region, which in CGE&Ys business structure consists of Denmark, Finland, Norway and Sweden. We want to point out that this is also the definition of the Nordic that will be used throughout this thesis. The Nordic region is its own profit center, or business division, that had a revenue of 5 367 million SEK year 2000 and answers to the French parent company as one unit. The largest single market in the Nordic region is Sweden, that had a revenue of 3 849 million SEK year 2000, in which there currently are 3 300 employees. The headquarters for the Nordic region is in Alvik Strand in Stockholm, Sweden.1 1.2.2 The bank situation in the Nordic region of CGE&Y

The company-branches different head offices, in the countries mentioned above, have up until now employed different banks. CGE&Y have realized that they have been exposed to a financial cost and currency risk2 but havent been able to change their rather awkward situation. This cost is composed of the spread in currency trading and bank cost of transferring cash between different banks internationally. The currency risk is constituted by the fact that the company is exposed to currency movements in different situations. In an attempt to try to avoid this currency risk and cost exposure and to facilitate and speed up financial transactions, CGE&Y management decided to switch banks and employ only one single bank for the Nordic region. As a result, the company is working on implementing the Swedish bank Svenska Handelsbanken, from here on referred to as SHB, as the main bank for this region. SHB operates in most financial markets around the world. The SHB implementation is supposed to be fully operational in late summer 2001. By this time the countries involved are supposed to have gained access to SHBs Internet based system for multinational corporations called NordicLink2. It is important to point out that the SHB implementation in no way restrains CGE&Y to do business with other banks in Sweden or in any other country. Most Nordic banks are capable of offering corporate services in each of the Nordic countries. This aspect will not be any different compared to how CGE&Y was related to other banks before the SHB Bank 4 implementation. The big change is that Foreign Bank 3 all branches employ the same bank, bank 2 SHB, as its main bank and have the same account structure in each country. CGE&Y Figure 1 display how CGE&Y relates to SHB and other banks active in the Nordic. The arrow pointing both ways between CGE&Y and SHB is larger in order to exhibit that this is where the main cash flows are.Foreign bank 1 SHB Bank 1 Bank 2

Figure 1; CGE&Ys bank relations

To employ a single bank is one part of CGE&Ys plans to set up a new finance center situated in the headquarters of the Nordic region in Alvik Strand, Stockholm. The purpose of the finance center is an effective management of all short-term financial investments of excess cash, which is a part of Treasury Management. This will be made possible through the new1 2

CGE&Ys website, interview with Anna Bellman See definition in the glossary, Appendix A p. 53-57

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bank account structure provided by SHB. A requirement by the management is that the finance center should not be too advanced to operate. In fact, when up and running, only one person is to be able to administer the finance center. The estimated time requirement is around one to a maximum of two hours per day. A premise for this to function smoothly and effectively is that some kind of system, perhaps an action matrix or guidelines and recommendations, by which the finance center is administered has to be thoroughly planned. Certain courses of action has to be staked out, each one depending on what conditions, both macro- and company specific micro factors, are present at every situation, from day to day. Before describing any details we would like to clarify certain important relationships. The branches in the Nordic region are all individual legal bodies. Further more, the branches involved will have just about the same bank account structure as CGE&Y Sweden has, which is displayed by figure 2 and described below. It will differ only in the sense of numbers of business fields and internal structure of these. According to Petersson, our contact person on CGE&Y, the NordicLink system provides a number of benefits. Among these is the ability to more easily borrow money internally within the company to avoid bank charges such as unnecessarily high interest costs due to usage of the companys bank credit and short-term loans. This needs some more explicit description, which is done below. The system also simplifies the overview of the Nordic regions current cash within the different Nordic branches. The CGE&Y bank account structure in Sweden can be illustrated as the following;

Sweden

CGE&Y AB

Telecom

NIS

CGE&Y Sweden joint bank account in SEK

CGE&Y Denmarks account in SEK

CGE&Y Finlands account in SEK

SSC

CGE&Y Norways account in SEK

Figure 2; The Swedish CGE&Y bank account structure

Figure 2 displays the different main accounts underneath the joint bank account3. In Sweden, CGE&Y has five different business fields as can been seen on the left hand side. CGE&Y in Denmark, Finland and Norway has its own SEK accounts, which are displayed on the right hand side. These accounts do origin, as must be understood, from the legal bodies of CGE&Y Denmark, Finland and Norway, and are not owned by CGE&Y Sweden in any way. However,3

See definition in the glossary, Appendix A p. 53-57

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these SEK accounts are connected to the Swedish SEK joint bank account. Each of these accounts are in turn connected to the Danish, Finnish and Norwegian joint bank accounts respectively and exist only for the possibility to pursue netting4 in SEK. Exactly the same bank account structure will exist for each countrys EUR joint bank account, see figure 3 for further description. As an example of netting in SEK, say if CGE&Y Denmark receives a payment in SEK, the Swedish CGE&Y can use that payment to net out underbalanced accounts. However it might not be too likely that CGE&Y Denmark accepts payments in SEK. To give another example, suppose that CGE&Y Denmark is low on liquidity and that CGE&Y Norway temporarily has got excess cash. Then the two branches can help one another by utilizing NordicLinks transfer system. The Norwegian branch can quickly transfer cash to its account in Denmark in order to avoid external short-term borrowing for the Danish branch. But, this does involve exchanging NOK to DKK that constitutes a transaction risk4 if hedging4 is not involved. It also involves at least two transactions cost, the spread in the currency exchange rate, and the spread in a forward or spot exchange rate on the way back from DKK to NOK. These costs are assigned to the Danish branch since it is that branch which is in need of liquidity. They will also have to pay an internal interest rate to the Norwegian branch for the loan. However, one explanation for these kinds of procedures is that it is much cheaper than an external shortterm loan from a bank. Note that these procedures recently described are not netting in its genuine sense that netting is defined. Every country that makes up the Nordic region will after the SHB implementation have two joint bank accounts. One in its national currency and one in EUR. The exception is CGE&Y Finland since Finland already has converted its former currency FIM to EUR due to its membership in European Monetary Union. The new bank structure in combination with NordicLink will provide a lot of advantages compared to how things were done before, as stated above. As figure 3 shows, CGE&Y will be able to transfer EUR between the Nordic branches. Presently, this will be especially favorable for CGE&Y Finland. Theoretically, it means that the Finnish SEK account Finnish branch will be able to borrow EUR from all CGE&Ys EUR account or any of the Nordic branches through a EUR account simple transfer without neither risk nor cost, since it is the same currency. Because the significance of EUR can be expected to grow, this thought is quite appealing. DKK account NOK account Figure 3 in combination with figure 2 shows that currencies has to be exchanged when transferred to another branchs joint bank account if it is not EUR that is being transferred.EUR account EUR account

Figure 3; Joint bank accounts in the Nordic region

However, according to Petersson, there is a drawback in the negotiated agreement between CGE&Y and SHB. CGE&Y will not be allowed to perform netting in its genuine sense on the different joint bank accounts between the Nordic currencies. CGE&Y have also been told that there will be a fee imposed on transfers of EUR between different EUR accounts.4

See definition in the glossary, Appendix A p. 53-57

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Another disadvantage in the new bank structure is that the foreign currency accounts5 that each business field holds in the different countries cant be connected to the joint bank accounts. That is, the amounts on each currency account will not be accumulated to the joint bank account and hereby will not be subject for a larger amount to invest in the market. But, CGE&Y can still view the balance on the currency accounts. It is SHB who basically wouldnt accept a netting procedure. One should note that, the different currency accounts has various interest rates. The interest rate on the different currency accounts reflects each specific countrys interest rate level. For example, a USD currency account has the American prime rate less the banks margin. The accumulated excess cash portfolio in the Nordic region is estimated to vary from 0 to 650 million SEK per day. This is the money that needs to be overviewed and a big concern has to be taken into maximizing its returns. The risk that has to be taken into account, when making investments, is colored by the risk policy employed by the company. Today the company invests its excess cash in each country and, of course, in its domestic currency. This means that there are different returns on the money in each country depending on differences in interest rates. Further more, the over-night investments5 are made in the afternoon of each day. When the company can set off cash for longer time periods than over-night, the company mainly uses corporate and real estate certificates5. The company has not been offered Treasury bills5 from the bank, this is simply because it yields a lower rate of return. Today CGE&Y Sweden earns around 3,95% annual interest on its over-night investments. The cash flows generated in each Nordic country are converted into EUR for accounting purposes only, since the whole CGE&Y group presents its results in EUR. This means that there is no actual exchange taking place but it imposes a translation risk5. The money hereby stays in each country in each domestic currency for ongoing business purposes, except perhaps for the share of profits that are repatriated to the parent company in France. The exception is Finland that already has converted to EUR.6 There are various instruments that might be used when minimizing currency risk. When management is to decide how to invest excess cash, one must investigate what would be best for the company. To be considered are, among other things, planning of time horizon, liquidity needs and that the investment at the same time is consistent with the companys risk policy. Perhaps there are better ways of investing the excess cash compared with today. The company has not, until now, taken enough time to overview and investigate alternative opportunities, investment alternatives and bank systems. 1.2.2.1 Transfer deadlines One could think that it is a good idea for the company to shop around for higher interest rates of return, advantageous currency rates and so on. There is a problem though. In Sweden there is a deadline at 11.00 for bank transfers for amounts less than 10 million SEK of value and 14.30 for exceeding 10 million SEK. This differs a bit between banks and is dependent on agreements between the bank and the company, but hold in general7. This has to be considered when using different banks cause the company can loose valuable interest yield by not investigating from day to day which investment opportunity would give the best income.5 6

See definition in the glossary, Appendix A p. 53-57 Interview with Anneli Petersson, CGE&Y 7 Interview with Haller at Ericsson and Torberger at SAS

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Even though CGE&Y mainly uses SHB, it also employs other banks from time to time when they can get a more advantageous deal from the competitors.8 1.2.2.2 Hedging foreign payments and receivables For hedging purposes CGE&Y in Sweden currently uses forwards9, mainly through SHB. All payments and receivables over 500 000 SEK are hedged. Sometimes they also use other banks, though there is an interest rate risk9 in doing that. Say if the company buys a forward in dollars and later on doesnt need the dollars, it has to make a foreign payment, which is costly, both in bank charges and interest rate losses. The company is investigating the possibility to use options9 for hedging purposes when they are making offers in other currencies. Even though this might be a costly hedge caused by the premium paid when buying an option, it is a good hedge for uncertain offers and perfectly offsets any currency risk.8 1.2.3 CGE&Ys risk policy

CGE&Ys management is working on implementing a risk policy, which will state that CGE&Y is not willing to expose its obtained earnings to any risk at all. The policy proposition is about to be over reviewed but is not accepted yet. However, the main statement in the policy is that the company shall invest with caution. This is of special concern when investing in corporate certificates, which according to CGE&Y should be K1 or AAA rated9. Though, there is, and will continue to be, a list of exceptions for companies and communities that are not rated at all. This list is continuously updated by CGE&Y themselves. Most of these certificates are issued by for example large communities and well-known companies like Ericsson, which are rated but neither K1 nor AAA rated. Further more the policy states that Treasury bills, bank certificates and bank owned company certificates are also accepted. The time horizon for investments is to be set to at most one year. The financial center is to decide how to invest, what amount and for what time to invest, but has to work within the frame of the risk policy. The policy is set since it is not the companys core business to operate in the financial market. CGE&Y is to make money on its consulting operations and not speculate and gamble with money earned. As stated earlier, all payments and receivables over 500 000 SEK shall be hedged according to the risk policy.8 1.3 Definitions

To enable a complete understanding of the thesis, some definitions must be done. We include these definitions because they are relevant to the subject and for better comprehensibility to the reader. 1.3.1 Definition of Cash Management

Every company is interested in maximizing its profits in the longer perspective. This is because the company is obligated to satisfy its shareholders in the long run. This can be done8 9

Interview with Anneli Petersson, CGE&Y See definition in the glossary, Appendix A p. 53-57

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not only by rationalizing the companys operations but also through skilled and effective management of the companys working capital. This is referred to as Cash Management and its main purpose is to improve the handling of a companys liquidity and cash flows. Lots of capital is often unnecessarily bound because the companies dont have effective routines to handle its liquidity. This can be revised in a number of ways and with different measures. The definition of Cash Management is different depending on which author or group of authors one asks. Basically one can break down the components of Cash Management into the following, which has been established for Nordic conditions10: Systems for incoming payment Sales ledger Systems for outgoing payments Purchases ledger Administration of liquid cash Currency administration and management of currency risk exposure Short-term borrowing

The points stated above are the main parts that are overviewed and considered when working with Cash Management. In a financial statement successful Cash Management is revealed in a higher interest income and in an improved net financial result. One has to consider that the improvement in income shall be weighted against the risks that the company is willing to take, for example when deciding for a reduction of liquid assets or if customers leave the company due to shortened periods of credit.11 1.3.2 Definition of Treasury Management

Sometimes Treasury Management is used as synonymous to Cash Management, but there are differences. Compared to Cash Management, Treasury Management focus more on the process of short-term investment, or lending, and borrowings12, and the process of assuring that decisions are in accordance with the companys risk policy, the three last stated points of the Cash Management components. Treasury Management can be defined as follows: The management of monetary assets and liabilities, financial risk and banking relationship in such a way as to maximize yields, minimize costs and control risk subject to the agreed corporate policy13. Further more one can state: The treasury function in most corporations will vary, depending on its size, complexity, geography and organization13. One has to consider the different flows in the company as follows: These flows have four aspects: amount, currency, time and place. Of course each aspect must be managed. One of the most important of these is maintaining liquidity to ensure that the right amount of funds in the right currency are in the right place at the right time. We want to point out that this definition is viewed from a company perspective. The definition would have embraced more and different factors if it had been out of a banking perspective.14

10 11

Cash Management fr fretag, p. 13. Cash Management i Fretag, p. 11-14, International Treasury Management, p. 1, 63-71 12 Cash Management fr fretag, p. 15 13 International Treasury Management, p. 1 14 International Treasury Management, p. 1, 9, Treasury Management, p. 6-11

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1.3.3

Definition of excess cash

The term excess cash is mentioned throughout this thesis. We defined the term in consultation with CGE&Y as operating capital, which will be, but isnt needed in the ongoing operations for a certain period of time. Excess cash arises from temporal liquidity surplus. It is accumulated from day to day. It is this excess cash that need to be invested in short-term instruments to give the best yield possible. 1.4 Problem

Interest rates differ from country to country and are always changing. In the same way the currencies are changing against each other although a lot more often. The financial theory states that the interest rates move the currencies in the longer run15. One also knows that it is, more or less, impossible to predict the movements of currencies in the short run. One can say that it is the same probability that a currency appreciate as well as it can depreciate16. Because CGE&Y earlier have employed different banks in the different countries but now will have the same bank it has a different new situation to adapt to. The company is not quite familiar with how to handle some of the new possibilities. Where should one invest the money, the excess cash, to attain the most efficient management of company liquidity? Earlier the obvious choice for the company has been to invest in different financial instruments in each Nordic country. This was a direct consequence due to the separate economic functions. With the new bank situation the company can transfer money easily and cost efficient between the Nordic countries. If the company would like to invest money in another country, it deals with a challenge. When exchanging money, a non-wanted currency exposure to risk arises. There are hedge instruments for such risks, but the question is if there are any economic incitements to do these transactions using hedges, and currency exchanges, since theory tells us that the financial markets are just about perfect. The capital market parity applies in theory, but how does it work in practice? 1.4.1 Posing of the problem Is it profitable to transfer money and exchange them between the Nordic countries in search of the highest rate of return? Purpose

1.5

The main purpose of this thesis is to investigate if it is worth for a company like CGE&Y to transfer and exchange money between the Nordic countries and to hedge in purpose of gaining a higher rate of return on the investments of the companys excess cash. Through our investigation we have the ambition to present recommendations for the company how to act. A partial purpose is also to investigate CGE&Ys bank situation on an over-night basis. The reason for this is because the purposes are linked together through a common goal of Treasury Management, to attain an effective management of company liquidity and to achieve the highest possible rate of return.15 16

Multinational Finance, p. 90-99 Multinational Finance, p. 93

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1.6

Limitations

In this thesis we will not consider the whole financial portfolio of CGE&Y. We will look upon investments on three time references, one and three months perspective and we will investigate CGE&Ys bank situation on an over-night basis. It is very rare that CGE&Y makes investments on a longer time period than six months, if even that long. In order to limit the scope of our investigation we had to make a selection of time references. We also want the thesis to be as practically applicable as possible to CGE&Y. This is why we choose one and three months as examples. Only by CGE&Y considered risk free investments in the Nordic region will be dealt with in the thesis. We will only investigate the investment part of the subject Treasury Management since this is what CGE&Ys finance center mainly will work with. A factor that has further limited our work has been the strict bank secrecy. This has forced us to generalize certain facts and data. Due to lack of time we could not interview for example capital administration departments at insurance companies. We would have wanted to conduct our benchmarking more thorough.

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2 MethodBefore starting working on a thesis we had stated two goals for ourselves. The first one was the ambition to write the thesis in English. This ambition origin in the belief that it would be an instructive challenge and that it might be worthwhile in the future to have a thesis in an international language. After all, we are studying International Business. The second goal was that we should get in contact with a company to be able to get an assignment that is directly related to reality. We believed it would be more fun, challenging and meaningful knowing, or at least hoping, that someone would be able to use whatever facts we were to conclude. We got in contact with CGE&Y through a contact we know who is employed by the company. The reason for choosing CGE&Y was that we think it is an interesting company that operates internationally and that very well could be a future employer to us. Another reason is that we managed to intercept CGE&Y while still in the process of developing a finance center. Through the company we got introduced to the subject Treasury Management. Previously we had merely touched the subject in one of our courses, International Finance. CGE&Y wanted help investigating the problem stated previously. After reviewing and correcting the assignment to meet the demands from our advisor we started off by reading literature to learn about the subject Treasury Management and its functions as a whole. We used the Universitys library database to search for related literature. We ordered literature through the library, which we had got recommended from professors and researchers of financial business and economics. We soon realized that it is a huge subject that contains, among other parts, both borrowing and lending of short money for an organization. In the process of getting deepened into the subject we also searched the Internet for old theses and working papers. The database on the Swedish school of Economics was useful in finding relevant working papers. There were several previous working papers that had conducted research on related subjects, but not too much on our specific case. It was hard to find specific literature and information about the subject in the beginning. But we found literature or working papers that investigated our specific problem. The literature contained facts about the capital market parities and related implications of it. However we never found any investigations similar to ours. Continuing contact and interviews with our advisor and our contact person on CGE&Y meant a lot to make sure that we were going in the right direction. We interviewed Gabriel Oxenstierna, Ph.D. of economics at Sdertrns hgskola, to get a good overview of the banking aspects. He also recommended some literature and a few Internet sites. As the work progressed it became clear that we were to use a qualitative method. The subject is to complex to enable standardized surveys to provide information that would be of value to us. We needed to do deepened interviews. We also concluded that we were working with a hypothesis in a manner that is similar to an analytical inductive method17. This means that we collected data relevant to our problem and after that we started analyzing the collected data. When we dug deeper into the subject an experimental calculation model started to take form. At first we were thinking of a calculation model that were to take into account the different interest rates between the countries plus a number of other macro factors. We were considering CGE&Ys possibilities to make arbitrage business, so the model that we were17

Frn datainsamling till rapport- att gra en statistisk underskning, p. 241

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going to use was based on the Covered interest arbitrage model18. In the model some figures were needed so we searched the Internet for current and historical inflation-, interestand exchange rates. These figures were to be found on the website of each countrys central bank. We wanted to be consistent and decided to use a mean of the interbank deposit19- and lending interest rate from each country. We decided this due to that the differences in deposit and lending interest rate spreads were so large in some cases that we thought that it would be more truthful to use the mean. The exchange rates were easier to deal with; we simply used the mean here as well, but in this case the spreads were lower. We believed that using the mean would be correct in the long run due to the fact that the company both sells and buys currencies; there are cash flows both ways. Even though there are spread charges, we decided to simplify it this way. The inflation rates, that also were to be found on the central banks web sites, are fixed which means that they are real, stated figures. We were in contact with SHBs trading center, to set up an interview appointment. For the purposes of learning how the markets actually work, how exchange and forward rates are set and even more interesting, how spreads are set and what these decisions are dependent on. But they denied us and where just not interested. We didnt contact any other bank in this purpose, simply because SHB is CGE&Ys main bank. We hoped that we could se how SHB work with CGE&Y in specific. This posed a problem, because we wanted to get into the subject from a reality, or practical, point of view. We were also in contact with Postgirot, the Swedish counterpart to the Postal Giro, to get some information on different investment opportunities and forward rates. When we first started of we thought that we would be able to investigate the whole treasury situation in CGE&Y. We figured out that we had been too wide in our problem, purpose and limitation. The complete subject would have been too hard to grip and we decided to restate these important parts. When restating them we decided to concentrate on the investments on one and three months period in combination with if there is any economic incitements for the company to move money between the different countries. By doing this we got more focused on the subject and problem at hand and found that the purpose of the thesis would be clearer and more distinct for ourselves. 2.1 Validity

The validity is by definition to what extent the study measures what the researchers wish to measure, and to what extent subjective judgments have been avoided during the collection of data.20 2.2 Reliability

A study with high reliability should neither be affected by who is conducting the study nor under what circumstances it is considered.20

18 19

Multinational Finance, p. 91-93, Multinational Business Finance, p. 125-127 See definition in glossary, Appendix A p. 53-57 20 Vetenskaplig Metod, p. 67-72

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2.3

The interviews

In our research we have pursued benchmarking activities with a few Swedish multinational corporations. Our screening was conducted with four criteria in mind. We wanted the potential interviewees to, in an as large sense as possible, have similarities to CGE&Y. Not necessarily an operational similarity, but our sample should be dealing with both investments and borrowings and not just borrowings which can be quite common. Another criterion was that the sample could be assumed to have Treasury Management experiences. A third criterion was of course that our sample needed to be a multinational company that operates in at least two other countries except for Sweden. The fourth and last criterion was our possibility to physically reach our sample. That was why we contacted companies that are situated in the region of Stockholm. We finally interviewed Ericsson, SAS, and Scania. The reason for selecting these companies Treasury Departments was because they have been dealing with problems similar to those now faced by CGE&Y for years. We are aware that these companies are not of similar size to each other and to CGE&Y, but since their Treasury Departments are fairly large and we could assume that they might have answers and solutions to some of our problems and questions. We also tried to get in contact with ABB several times to set up an interview appointment. But that was not possible; they didnt have time for us. We believe this was a pity because rumors told us that ABB have long experiences of Treasury Management and are well known for this work. In fact, weve heard that ABB was the Swedish pioneers in Treasury Management. We were also in contact with AstraZeneca, Volvo and Assi Domn but because of various reasons it was not possible for us to visit and/or interview them. The first interview was with two persons at SAS Cash- and Treasury Management Department. Previous the interview we sent an e-mail with questions used as a basis for discussion, (see appendix). However, the questions were answered. In the interview we didnt follow the questions strictly after all. The interview turned out more like a discussion and information of the SAS Treasury work processes. We tape recorded the interview and typed it down for corrections and approvals by the interviewees. It was a truly valuable meeting and we learned a lot about how a large company work with treasury problems. The interview with Scania was done over telephone. We didnt see any reason for meeting them since they mostly are dealing with borrowings, which is not essential for this thesis. However, the reason for still conducting an interview was the interesting aspect of learning how a company like Scania issue corporate certificates, what sets the offered interest rates of return and so on. We interviewed three different persons on Ericsson Treasury Department. We went through the same procedure as with SAS by sending the questions and getting our interview corrected and approved afterward. We got a very good presentation of how the company works with their day-to-day financing. This was another turnaround for our thesis. It was subsequent to this that we decided to look upon investment from a day-to-day basis as well as one month and three months time and not just choose one or the other. This was probably a consequence of the information we got from Ericsson in combination with SAS. We interviewed Erik Bergstrm, Ph.D. of Finance at Sdertrns hgskola, and got more familiar with the subject from a theoretical point of view, which in our perspective sometimes is quite far away from reality.

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We find the interviews to have good reliability since we probably would not get any different answers from the interviewees even if we interviewed them several times. We also tried to mitigate any subjectivity from the interviews. Furthermore we found that the interviewees, more or less, are of the same opinion in most matters related to our subject. We cant say to what extent we, as authors of this thesis, have been influenced by the interviewees personal opinions. We believe the interviews possess a high validity due to the way they were thoroughly planned and carried out. A factor that stresses the validity is that they were tape recorded, typed down, compared to various theories and facts stated in the literature used and then sent back for eventual corrections and approvals. Since we have performed a qualitative study we had a close relation to the subject, which lowers the risk of receiving non-valid information. Any subjectivity is mitigated and minimized thanks to the literature comparisons and checkups. However, even though the questions were followed and answered they were really used in a large sense as a basis for discussion.21 Last but not the least we would like to mention the extensive interviews with Petersson at CGE&Y. We have interviewed Petersson at least four times and every interview has lasted for at least one hour. But further more, weve lost count of the numerous phone calls to her. 2.4 The experimental calculations

In the beginning of the thesis work we were thinking of making the experimental calculations on figures from each Nordic countrys central bank. But we also needed forward rates from the past and got in contact with SHB and Skandinaviska Enskilda Banken, from here on referred to as SEB, for this matter. However, as we would learn, the banks do not keep a record of historical forward or swap prices. The reason might be that these prices are calculated based on exchange-, interest rate- and inflation rates changing from second to second. Because of this we decided not to use the figures from each countys central bank but instead to use specific figures for CGE&Y. Even though one might think that it would be reasonable to use figures from every Nordic country in the experimental calculation, we decided that it would be enough to use current figures from Norway and Sweden only. The interest rates are presently higher in Norway than in any other Nordic country and that was the purpose of this simplification. Another reason is that this was what our contact person at CGE&Y was really interested in. We wrote an exact instruction (see the appendix) for our contact person, just how she was to achieve the figures from SHB and SEB to our experimental calculations. After sending the instructions we got in touch with her to make sure she had fully understood them. After we received the figures we made sure that she had followed the instructions step by step as well. We would like to note that, thanks to our course of action, the figures used in our calculations are not just approximated figures but exact figures that CGE&Y got from the banks in reality at the specified date and time. We then put the figures into the model we had been planning through the whole thesis progression. We believe the experiments to be highly valid and reliable. Partially due to the fact that we got these exact figures from and via CGE&Y by using our exact instructions and partially because the theories state that the parities do hold. However, we were not present to control the procedure. This is just a one-time experiment and we cant guaranty that CGE&Y

21

Frn datainsamling till rapport- att gra en statistisk underskning, p. 210

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at some point might get figures that enables arbitrage, especially if collected from a variety of sources. To answer our partial purpose, to investigate CGE&Ys over-night banking situation, we decided to make a couple of calculations. These calculations does not cover our whole overnight investigation but constitute an attempt to point out what the company could gain from attaining a higher interest rate on its over-night investments. The figures used in the calculations are both actual and an assumed higher interest rate figure. We believe these calculations to be valid but perhaps not all that reliable due to that we assume figures that we have chosen at our own discretion. We have also via telephone-interviews with both SEBs and SHBs Cash Management Departments tried to investigate the benefits and products that these two banks can offer in order to evaluate CGE&Ys current bank. The main book that we used throughout the thesis is Butlers Multinational Finance. This is a book that we got acquainted with in the International Finance course. The book is looking into the parities in the financial market, which are essential to the thesis. Another book that we have used a lot is Rosss International Treasury Management. This book gives a good overview of the subject itself and the market functions. Throughout the thesis work we have been in contact with our advisor and our contact person at CGE&Y to make sure that our thoughts has been consistent with their demands. We have tape-recorded some of the interviews here as well to make sure that we never misunderstood any information given. To get a good overview of the subject and to collect valuable information for the thesis we would like to mention that we also have made numerous phone calls to different persons at different companies, banks and authorities. Among these are phone calls to CGE&Ys CIO, Scanias Treasury Department, Standard and Poors, Freningssparbankens-, Nordeas-, SHBs- and SEBs trading centers, SHBs- and SEBs Cash Management Departments, Reuter and the central bank of Sweden.

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3 TheoryIn this section we will present theories and previous research that will guide us along the scientific path that we must travel in order to provide evidence and results leading to our conclusions. We will also present a slightly modified experimental calculation model. The modification was necessary to fit CGE&Ys situation. 3.1 3.1.1 Theoretical frame of reference The law of one price

The law of one price is also often referred to as purchasing power parity. The theory states that equivalent assets sell for the same price nationwide. The theory does however assume that no market frictions exist. This means that transaction costs, such as the spread in a currency spot, forward, swap22 or bank transfer costs is not taken into consideration. The presupposition for equivalent assets to command the same price is a highly liquid market. This means that one instantly can buy or sell large quantities of an asset with low transaction costs and no other trade barriers. In practice, purchasing power parity does not hold for all assets, for example cars. The price difference between countries can be large for two new cars of the same brand. This is caused by the actual existing market frictions like transaction costs, transportation costs, governmental restrictions, maintenance cost, storage costs and the like. For actively traded financial assets, such as foreign currency and deposits in the interbank market, liquidity is regarded as very high. Purchasing power parity nearly always holds within the bounds of transaction costs in these markets because arbitrage ensures that spot and forward exchange rates and interest rates are in equilibrium. The implications of the law of one price can be divided into four parities that will be explained below.23International Fisher relation Interest rate differential (1+id)t / (1+if)t Interest rate parity Expected inflation rate differential (1+E[d])t / (1+E[f])t

=

=Forward / spot differential Ftd / f / S0d / f

=Expected change in spot rates

Relative purchasing power parity

=Unbiased forward expectations

E(Std / f ) / S0d / f

Figure 4; Capital market equilibrium- the international parity conditions

22 23

See definition in glossary, Appendix A p. 53-57 Multinational Finance, p. 81, Multinational Business Finance, p. 112-115

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Figure 424 summons the implications of the law of one price, where i = nominal interest rate, d = domestic, f = foreign, t = time, E= expected, = inflation, F = forward rate, S = spot rate. These are the mutual relations that actively interact in the international capital markets. Together these relationships always strive the market back towards equilibrium in case any discrepancies should arise. Interest rate parity is the only actual- as distinct from expectedrates in figure 4. This relation is the closest and best documented of the relationships. 3.1.1.1 Interest rate parity Interest rate parity implies that the forward premium or discount between two currencies is determined by the nominal interest rate differential between those currencies for the period. The formula for interest rate parity is: Ftd / f/S0d / f = (1+id)t/(1+if)t. A forward premium or discount on the left hand side of the equation reflects the interest rate differential on the right hand side. Because each price in the equation is actively traded, the interest rate parity always holds within the bounds of transaction costs in the currency markets.25 Interest rate parity is essential for the main purpose of this thesis. According to Butler26 the interest rate parity is the only of the four relationships in the capital market equilibrium one can trust at all times, both in the short and long run. 3.1.1.2 The international Fisher relation The Fisher equation, also referred to as the Fisher effect, states that nominal interest rates are related to real interest rates and inflation rates according to: (1 + i) = (1 + r)(1 + ), where i = nominal interest rate, r = real interest rates and = inflation rates. If one solves this equation for the nominal interest rate one get: i = r + + r. According to Butler, its quite usual to approximate the nominal interest rate by adding the real interest rate to the inflation rate. But this approximation is only recommended when interest and inflation rates are low. Otherwise the margin of errors increases. The formula for the international Fisher relation, or the international Fisher effect, is; (1 + id)t / (1 + if)t = (1 + d)t / (1 + f)t. However, it is important to note that in this equation represents expected inflation and that the relationship therefore requires a forecast of the future rate of inflation. And, as also should be noted, forecasting the future is never an easy task. If the law of one price holds for real rates of returns in two different countries, then this would imply that rd = rf and that the interest rate differentials reflect inflation rate differentials according to the Fisher equation. In practice, this would mean that real interest rates across countries are the same, and that the only variable that constitutes the difference in nominal interest rates is the difference in inflation rates across countries. However, studies based on historical real interest rates and inflation rates lend some support to the international Fisher relation but they also prove that it doesnt always hold in the short run. The relation between inflation and nominal interest rates is poor. According to Butler, real interest rates are not equal across currencies and they fluctuate over time as well. But it does exist equilibrium for real interest rates. Investors are attracted to investment opportunities in currencies with high real returns. This will automatically drive currency prices upward and at the same time push the perceived yields downward together with the real interest rates. This mechanism restores24 25

Multinational Finance, p. 99 Multinational Finance, p. 90-93, Multinational Business Finance, p. 122-127, Currency Risk and Business Management, p. 25 26 Author of Multinational Finance

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equilibrium in the long run but at any given point in time there can be large cross-border differences.27 3.1.1.3 Relative purchasing power parity Since this relation in the international capital market equilibrium is not quite the issue of our thesis, we will only in short describe its implications. Relative purchasing power parity states that the expected appreciation or depreciation of the spot exchange rate is determined by the mean expected inflation rate over the period investigated. But, according to Butler, because neither expected inflation or expected future spot rates are traded, the relation only holds on average and therefore have little predictive power. Numerous studies show that exchange rates move in an almost random fashion even if the study is performed over a couple of months. However, in the long run, inflation differences do prevail, and exchange rates changes become more highly correlated with inflation differentials.28 3.1.1.4 Unbiased forward expectations Nor this relation is really the core issue of our thesis and we will only in short describe its consequences and relation to the capital market equilibrium as a whole. According to Butler, forward parity claims that forward rates are unbiased predictors of future spot exchange rates, as; Ftd / f = E(Std / f ). If forward parity holds, then forward premiums or discounts reflect the expected change in the spot exchange rate as in figure 4; . Ftd / f / S0d / f = E(Std / f) / S0d / f. It is the speculative activity that the arbitrageurs pursue that ensures that forward rates do not diverge too far from the markets expectations of future spot rates. However, unbiased forward expectations are no good predictor of future spot rates in the short run. Historical exchange rate percentage changes are greater relative to forward premiums or discounts.29 3.1.2 Covered interest arbitrage

Covered interest arbitrage is sometimes referred to as free lunch. As can be understood from the reasoning above interest rate parity states that if the parity conditions hold, there is no possibility of covered interest arbitrage. But it is through covered interest arbitrage in the currency markets, or rather through the threat of it, that equilibrium is ensured in the currency market. If a speculator manages to lock in an arbitrage profit, this would mean that his or hers counterpart looses the equivalent amount on the very same transaction. This is why banks use spreads to reassure themselves against losses. The levels at which these spreads are established is determined by the bank, in conjunction with the exchange, is based on the assessed maximum movement which may be expected in the market on any one day. If not arbitrageurs would be able to borrow in one currency and lend in another, and cover the difference in the foreign exchange market. The mechanism takes advantage of the interest differential that is not fully reflected by, or covered by, a forward premium or discount. This must mean, according to the theory, that if the theoretical forward rate does deviate from the actual forward rate, arbitrage could be pursued.3027 28

Multinational Finance, p. 96-99, Multinational Business Finance, p. 120-122 Multinational Finance, p. 93-95, Multinational Business Finance, p. 128-130 29 Multinational Finance, p. 95-96, Multinational Business Finance, p. 128-130 30 Multinational Finance, p. 90-91, Multinational Business Finance, p. 123-124, Treasury Management, p. 279, Currency Risk and Business Management, p. 21-22

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3.1.2.1 Which way should one go? When one is to take advantage of a disequilibria one needs to be quite sure of which way to go, that is, in which currency to borrow and in which currency to lend. As an example, suppose Ftd / f/S0d / f > (1+id)t/(1+if)t. This would mean that domestic interest rates are too low and foreign interest rates too high to justify the current forward premium or discount. For equilibrium to be restored, either one or all of these rates must change. In our example one should borrow at the domestic interest rate id and buy S0d / f, the foreign currency. Then lend at the foreign interest rate if and lock in an arbitrage profit by covering ones exposure with a forward at the forward rate of Ftd / f. If Ftd / f/S0d / f < (1+id)t/(1+if)t one go the other way around.31 3.1.2.2 Covered interest arbitrage in practice In practice, what a company can do is to monitor the markets current interest and exchange rate levels in the countries where it operates and to seek opportunities when the market isnt in equilibrium. But, the disequilibrium becomes an opportunity only when interest rate parity doesnt hold even within the bound of transaction costs. An easy procedure would be to collect information about interest rates on for example Swedish and Norwegian Treasury bills with a lifetime of three months. One would also need the spot exchange rate (StSEK/NOK) respective the forward exchange rate (FtSEK/NOK). Subsequently one can put the figures into the interest rate parity formula and easily calculate the theoretical forward exchange rate. If the theoretical forward exchange rate is any different from the actual forward exchange quote there might be an arbitrage opportunity. If an arbitrage opportunity where to come up a company can for example buy NOK for SEK and invest in Norwegian Treasury bills, at a higher interest rate, and at the same time sell NOK on a forward contract. The amount in the forward would be set equal to the Treasury bills principal amount plus the interest yield which the company easily can calculate thanks to the fixed interest rate. The forward contracts expiration date would be set to coincide exactly with the Treasury bill. What enables this is that a company would know before the transactions are made what amount of NOK the company would receive in three months and can therefore tailor-make its forward to perfectly offset any transaction risk. A transaction of this kind cant be classified as speculation but by enclosing the companys transaction risk it is merely a way to take advantage of an arbitrage opportunity in purpose of improving the companys financial result without putting the companys assets at risk. The costs involved arise from the transaction spread in the spot exchange rate from SEK to NOK and the costs/spread for the forward contract. Covered interest arbitrage is only prosperous when the market disequilibria are so great that the yield exceeds the costs involved. Another alternative is to use a currency swap instead of one spot exchange and one forward contract. In our investigation we shall see if the outcome would be any different. 3.1.3 Financial risk policy management

The way a firm deals with currency risk is a key element of financial policy. Failure to set risk management guidelines and then monitor the corporations risk management activities can expose a firm to financial loss or even ruin. Management must decide whether currency risk exposures will be managed, how actively they will be managed, and whether a firm is willing31

Multinational Finance, p. 92-93, Multinational Business Finance, p. 123-124

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to take speculative positions in the pursuit of its business and financial objectives. Failure to take action in hedging currency risk is de facto a decision to take a speculative position in foreign exchange. Yet a firm may choose to go well beyond a passive posture toward currency risk as it attempts to extract as much value as possible from the firms operating cash flows.32 3.1.3.1 Currency risk management Currency risk management can be divided into the following procedure: 1. Identify those currencies to which the firm is exposed, as well as the distribution of future exchange rates for each of these currencies. 2. Estimate the firms sensitivity to changes in these currency values. 3. Determine the desirability of hedging, given the firms risk management policy. 4. Identify the hedging alternatives and evaluate the cost/benefit performance of each alternative, given the forecasted exchange rate distributions. Select and implement the hedging instruments or strategy. 5. Monitor the firms evolving exposures and revisit these steps as necessary. The currency risk management should not be a one-time affair. It changes over time in essence of changing exchange rates, geographic distribution and product mix of the firm. The risk management decisions shall function as a framework to the companys Treasury Department.33 3.2 Previous research

Seminar Paper by Alan V. Deardorff This Seminar paper, written in 1978, examines the relationship between spot and forward exchange rates and domestic and foreign interest rates with transaction costs taken into account. Actually, apart from more conventional analysis, his seminar paper focuses on cost minimization rather than on profit maximization. He states that covered interest arbitrage is all about effectively exchanging, for example, current dollars for current dollars and making a profit in the process. Deardorff stresses that it is well recognized that some departure from exact interest parity is possible in the presence of costs associated with transactions on the securities and exchange markets. He also argues that, with the same conditions regarding transaction costs, conventional covered interest arbitrage will never occur at all. Deardorff concludes that covered interest arbitrage should prevent the percentage deviation of the forward rate from its interest-parity value from ever exceeding the sum of transaction costs involved. Deardorff writes about the phenomenon of one-way arbitrage which is an alternative way to achieve the same result as in a spot market purchase, that is, a replication of a spot exchange, at a potentially lower cost. This can be of interest for a market participant in demand of another currency since everyone is assumed to be rational in their actions and therefore trying to minimize costs in their quest for maximum returns. Deardorff explains that one-way arbitrage, or the market participants knowledge of its possibility, will prevent interest and32 33

Multinational Finance, p. 304 Multinational Finance, p. 320

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exchange rates from ever departing enough from the interest rate parity for covered interest arbitrage to even break even.34 Working paper by Kaj Hedvall Arbitrage opportunities exist in the market, but not often and they may be hard to discover. One can refer to Kaj Hedvalls research about this matter. He made computerized game experiments with both laymen and professional dealers. The game employed was a simulation task in which the participants acted as fund managers on a stock market. The hypothesis was that a positive number of participants would recognize risk-less arbitrage profit opportunities. However, the results revealed that none of the participants, neither laymen nor professionals, did in fact utilize the risk-less arbitrage opportunities present in the simulated market. By contrast, subsequent experiments showed that participants who had prior expectations about arbitrage opportunities did utilize the arbitrages.35 Article by Michael J Alfonsi The article presents a number of practices that companies that have achieved best-in-class status in international treasury and finance have in common. A couple of them will be described here. By best-in-class Alfonsi means companies that have achieved the lowest degree of risk, the highest quality of output or the lowest ratio of finance cost-to-revenuereceived. Alfonsi recons that the common practices stated below can be used as indicators revealing if a firm is on the right track in its treasury function development. 1. The finance structure is centralized. It is the way that these shared service activities are performed that results in a best practice. The staff must focus on conducting value-added activities to the business, particularly activities that provide decision support and improved business performance. 2. The finance and treasury cost base (e.g. finance as a percentage of revenue) is low. In international trade finance activities (e.g. letters of credit, currency purchases, currency hedges and credit disposition), best-in-class companies have reduced their all-in costs primarily by knowing each of their component costs, streamlining operations, negotiating prices and bundling services for leverage using a limited number of providers. 3. Reasonable risk factors are identified and mitigated. The usual risk concerns in international treasury (e.g. translation and transaction exposure management) are well managed by best-in-class companies but not over-managed. Forward contracts are consolidated and usually placed with one primary and one secondary counter party. Alfonsi also stresses that it is a good idea to have the risk management function within the treasury center. 4. Resources (time and money) are spent on information gathering, information management and personal communication. For best-in-class performers, quality information tools are not a matter of cost, but a matter of managing media (Wire services, Internet, rating agencies, reporting services and even TV and radio). Communication methods are not a function of budget, but a necessity for treasury center performance. 5. Structures are simple and constant improvements are sought.

34 35

One-way arbitrage and its implications for the foreign exchange markets Arbitrage in an experimental securities market

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Alfonsi concludes with stating that a three-faced approach, involving setting the direction, working out the details and realizing the benefits has been proven to be most effective.36 Article by Alpa Dhanani Dhanani states that in a perfect world, the movements in exchange rates occur so as to attain equilibrium positions between the interest rates and inflation rates of different economies in the market place. Disequilibrium positions create profitable opportunities for arbitrageurs, exploitation of disequilibrium results in movements in exchange rates, ensuring that the tendency in the foreign exchange markets is towards equilibrium. Similarly, the rewards for borrowing in a country with low interest rates would be offset exactly by the disadvantage accrued, as a result of the revaluation of this countrys currency. As quoted in parent currency terms, the relatively low interest repayments in the foreign currency would amount to the same situation as borrowing in a high interest currency. Dhanani continues by discussing the parities and the spreads in the forward currency exchange market. He refers to the Market Expectation Theory, which states that forward exchange rates predict future spot rates accurately over time. In this instance, according to the theory, currency risk management with forward contracts is of little value, since the forward rate will on average equate the future spot rate. In fact, in light of the higher bid/ask spread on forward transactions as compared to spot exchange transactions, avoiding cover should be more profitable. But on the other hand Dhanani say that failure to manage exchange rate risk will increase the volatility of the levels of profits or may even result in financial distress. Further on Dhanani states that movements in exchange rates do not necessarily occur to neutralize effects of interest rate and inflation rate differential only. In that case management of risk during these periods may add value to corporations. Value can be added in one of two ways: By reducing the adverse effects of exchange rate movements (and increase the positive effects of favorable exchange rate movements); or By reducing the potential variability of cash flows and profit levels.

He concludes that the Market Expectation Theory does not work in at least the short or medium run in practice. He states an example that originate from the time when he wrote the paper (March 2000): UK interest rates are relatively high as compared to those in Europe, yet the pound sterling is stronger than the euro. This situation does not conform to the predictions of the International Fisher Effect, which hypothesizes that currencies of countries with relatively high interest rates should depreciate.37 Article by Eric A Bloom This paper deals with the treasurers objectives and the risk involved. Bloom says that the treasurers primary aim is to invest cash responsibly, which means not losing the principal and ensuring cash availability when its needed. According to Rich Jones, an investment advisor, which is quoted in the paper states that; no matter where a treasurer puts the companys cash,

36 37

Best practices in international treasury management To hedge or not to hedge

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it is exposed to risk. He continues with the trick is to recognize what those risks are, and factor them in with the costs, convenience, and yield of each investment alternative. Bloom continues by saying that even an AAA-rated bank cannot unconditionally protect the investor from risks of the end investment. However, the stronger the bank, the more capable it will be of handling problems if something goes wrong. The question can you earn a higher net yield with less risk? is discussed in the paper. Bloom says that the answer is yes, but there are no shortcuts. Simply pursuing the highest short-term yield will likely expose the companys funds to more risk than is appropriate for its cash reserves. Performance can be more safely improved by a combination of reducing the costs of investing and by more selective buying of securities.38 3.3 The modified experimental calculation model

In order to investigate if the market parities really hold in practice we have to make a couple of calculations based on figures collected from SHB and SEB, through Petersson at CGE&Y. In the appendix the instructions are enclosed. The interest- and exchange rate quotes are dependent on how the bank perceives the company, accounting for both company size and profitability for the bank (size and number of transactions), how good the personal relations are and how creditworthy the company is39. We will use the model of interest rate arbitrage presented previously. However, we wont follow the theory exactly. The definition of arbitrage is: a profit obtained with no net investment and no risk at all40. We have modified the theory to fit CGE&Ys situation by putting in the companys own working capital, its excess cash, in the model. This means that there is not really arbitrage we are looking for, but a risk-less capital profit. We will from here on follow the different steps of the original model to obtain arbitrage profits, but not in its original sense. A number of experimental investment calculations will be presented in the investigation. The experiments all assume an initial amount of 100 million SEK that are to be invested in Norway. We have been using 100 millions as an example and is a fictive amount. The reason for choosing Norway is that Norway presently has a higher interest rate level. The time horizons for the experimental investments will be one and three months. What we will do is as follows; 1. Convert SEK to NOK on the spot currency exchange market 2. Invest the NOK amount in the Norwegian deposit market, through the defined bank. 3. Hedge the calculated amount, that is, the principal amount plus interest income, with a forward contract that perfectly matches the final amount. This result will then be compared to the final amount that CGE&Y would acquire if the same amount of money were invested in Sweden only. We will also make one calculation that represents the other way around, that is, sell NOK for SEK, invest in Sweden and buy NOK for SEK on a forward contract. This procedure will be compared with an investment done in Norway.38 39

More reward with less risk: Investment options for corporate treasury Interviews with SHB Trading Center, Haller at Ericsson and Torberger at SAS 40 Multinational Finance, p. 82

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The calculations prerequisite that one only consider these both banks figures as they are quoted in the diagrams, in investigation and results. That is, we will not consider different investment alternatives, for example corporate certificates, which in general, give a higher yield than the banks deposit rate41. The reason is that we wish to investigate if the parities hold in general. According to SEB Trading Center in a telephone interview we learned about the differences between a forward contract and a swap contract. In the sense that we will use these two instruments in our experimental calculations, there will be no different results. This can be viewed by the figures 5 and 6 below. There would be a difference only if the spot and forward transaction were not to take place at the same time. The explanation for this is that the exchange rates will most probably differ between the two transactions, which however will apply a risk into the transactions. The swap transaction make sure by nature that both the buy and sell side of the transaction will take place at the same time. Swaps are the most used instruments, thereafter forwards, least common is futures42.43 Figure 5 can illustrate the swap deal:Spot rate

Sweden

Norway

Spot rate + pips Investment in Norway

Figure 6 can illustrate the forward deal:Spot rate

Sweden

Norway

Forward rate

Investment in Norway

These two figures shows how we have been thinking in the experimental calculations. As can be seen, both procedures start with buying NOK on the spot market. Thereafter an investment is made in Norway. The forward rate, in this case, is dependent and calculated on the actual41 42

Interviews with SHB and SEB trading centers See definition in glossary, Appendix A p. 53-57 43 Telephone interview with SEBs Trading Center

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differences in interest rates between Sweden and Norway. The pips44 in the swap deal are also dependent and calculated on actual interest rates as in the forward deal. This is why we will not perform any calculations on the swap figures since it would give the same result as with the forward figures. 3.4 The 11 oclock rule

We decided to call the transfer deadline between different banks, for amounts less than 10 million SEK, the 11 oclock rule. This rule implies that a company has a stronger bargaining position before 11 oclock due to the possibility to transfer money between banks. This means that a company can shop around for greater yields on its investments. We do these calculations because CGE&Y currently invest all its excess cash in the late afternoon of each day and hereby puts itself in a very bad bargaining position. We are going to make an experiment to investigate the possible gains involved if CGE&Y could attain a higher interest rate on its over-night investments due to making the investments before 11 oclock. We will assume an assessed amount of 100 million SEK excess cash that is on CGE&Y Swedens account before 11 oclock. The first alternative that we calculate is based on how CGE&Y invests at current, that is, in the late afternoon, which yields the over-night annual interest rate 3,95 %. The second alternative is calculated on an assumed potentially higher interest rate that CGE&Y can get due to making its investments before 11 oclock. This annual interest rate is set to 4,05 % and is chosen at our own discretion after considering information about the 11 oclock rule given by SAS and Ericsson. The third alternative supposes that CGE&Y out of precaution decides to set off and invest 70 % of the initial amount before 11 oclock to the annual interest rate 4,05 %. The remaining 30 % is maintained available in case emergency payments would come up during the day. The whole idea would be ruined if CGE&Y instead would find itself with a liquidity shortfall and have to utilize the relatively expensive bank credit. The remaining 30 % is invested later in the afternoon at the lower annual interest rate of 3,95 %. The calculations are done on one-year basis as well as a day-to-day basis.

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See definition in glossary, Appendix A p. 53-57

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4 E m p i r i c a l i n v e s t i g a t i o n a n d re s u l t s

4.1

Investment alternatives for CGE&Y

Among the investment alternatives for CGE&Y, both such alternatives that we have found and alternatives perceived by CGE&Y, we have rejected a few. Among others, we found that Posgirot offered similar services to companies that banks do. But, after further investigation we found that their offers where not quite as good as the banks because of lower interest rates on short term investments and the fact that there was no possibility of direct transfers, with immediate value dates, between the companys bank account and the Postal Giro account without losing valuable interest rate days. There are several different instruments the company can invest in. Such as in Treasury bills, Treasury notes, bonds45, corporate- community- and real estate certificates and also in the deposit market. There are different and/or several risks in the stated instruments above, but most of them are in general considered as relatively low-risk investment alternatives. Examples of high-risk investment alternatives are shares, options and different indices that are more speculative instruments, which CGE&Y will not use due to the companys risk policy. When investing the excess cash one must have in mind how liquid an investment should be. This can differ from time to time and very much decides which instrument to use. If there might be a possibility to lock in cash for say three months the company has to look for the highest yield fo

Treasury Management Thesis

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