Question 10: I am in the process of establishing bench mark rates to set Long Term (1-5years) intercompany interest rates for borrowing or investing in the Parent Company. During my last role in the UK, we based long term rates on 3 month LIBOR + / - the margin available to the parent + the spread in basis points between the two entities' credit ratings. I am now looking to implement this at my new company, but was not really sure why a 3 month LIBOR basis was used, opposed to any other term. It is obvious why I would use the O/N LIBOR for ST funding < 1yr, but not so clear for longer term. Do you have any advice you could provide on this? What is best practice? Could you point me in the right direction for some published articles or guidance on this area, not necessarily specific to Australia?

Submitted by D Howarth - Treasurer, Australia on 27/3/2009

The Doctor's Answer:

Dear David,

Many thanks for your question on transfer pricing on intercompany lending. In response to your question, the approach you suggest is right on the money in terms of establishing credit margins. The credit margin should reflect the term of the borrowing, even if it is a margin on a short term floating rate.

With respect to term you should select a maturity profile that is consistent with how a treasurer would manage an external asset and liability management policy. This is therefore dependent on the underlying business of the subsidiary with some businesses better suited to short term and some to long term funding. Similarly, some businesses are better suited to floating versus fixed rates.

With transfer pricing, the rule of thumb is to try and reflect internally what you would do externally taking into account all commercial factors including prudent treasury and risk management.

I do not have any off-the-shelf material such as articles to send you on this topic, but would be pleased to put you in touch with one of my treasury colleagues in Australia or New Zealand who specialise in transfer pricing for treasury if you would like further details.

Kind regards
Sebastian.

Question 9: I would like to be informed more about transfer pricing models in ALM desks. How transfer pricing is made to treasury trading desks and other bank products (such as loans, deposits etc.)

Submitted by Ipek Ersak - Finansbank, Turkey on 23/2/2009

The Doctor's Answer:

Dear Ipek

Thank you for the very good question which is being raised a many banks in the current market environment.

Transfer pricing is important for two reasons: On the one hand it helps to calculate the margins of products and banking activities before entering into a transaction (forward looking) and on the other hand, it measures the performance of different profit centres, e.g. Treasury, Sales, so it is backward looking also. Consequently, transfer pricing is a tool for senior management but also the different departments of a bank to make (strategic) decisions and to identify the performance contributions on all levels of the bank (branch, departments, sales teams, etc.). Furthermore, it supports setting the right incentives for management, sales teams and traders and is therefore an important framework which should be implemented in every bank.

Generally, transfer pricing segregates the performance of sales (selling products to customers) and Treasury (being responsible for risk management) or Trading. For instance, given a 5 year fixed loan, the successs of the sales desk is the margin generated by this loan. This can be calculated using the 5 year swap rate to refinance hypothetically the loan to hedge interest rate risk. The result is the gross margin. Please note, that in this case it does not matter, if Treasury will really offset the interest rate risk - this is a separate decision not made by the sales desk.

Furthermore, credit risk (expected and unexpected loss) as well as the costs of operationally running the infrastructure supporting the loan (e.g. staff costs, IT costs, etc.) are deducted from the gross margin to produce a net margin - which should be positive. This net margin reflects the performance for this particular product. Of course, calculating the (hypothetical) margin of each product can then easily be aggregated to different levels of the bank such as a category of products, a branch or the whole bank.

Besides selling the product to clients, the 2nd source of the bank's performance is the Treasury which could either offset interest rate risk or can somehow speculate on it (e.g. by positive maturity transformation, meaning for instance refinancing the loan in the example above by 1 year). The same could be applied to credit risk management and each profit centre is measured in isolation. When consolidating all cost and profit centres based on the transfer pricing methodology, the final result will be in line with the bank's total performance.

When looking at trading desks, one methodology could be to look at their funding situation, i.e. to consider funding costs for positions which could be used for secured and unsecured funding. One model which may be applied is the so-called Cash Capital Model.

As you can see, transfer pricing is a relatively complex topic and the specific solution depends on the structure and activities of the bank. It is important to define a methodology and afterwards implement it appropriately. One lesson learned from the current crisis is that banks which had an appropriate transfer pricing framework and thus set the right incentives for staff, suffered less than those which did not do so.

I hope this overview provides a starting point in answering your question. For further reading in this area in which literature is sorely lacking, we attached a survey from PricewaterhouseCoopers performed in 2006 / 2007 which also covered the topic transfer pricing.

If you have further questions please let me know. We have been doing work for some large banks recently in this area and would be able to share thoughts based on practical experience. I'd be happy to arrange a conference call with one of our specialists who can answer further questions you may have on this difficult and very current topic.

Kind regards,

Sebastian di Paola.


ALM benchmark survey: http://www.pwc.ch/user_content/editor/files/publ_bank/pwc_asset_liability_mngm_bm_study.pdf


Sebastian di Paola
Partner
PricewaterhouseCoopers SA
Avenue Giuseppe-Motta 50
CH-1211 Geneva 2
Switzerland

Direct phone: +41 58 792 9603
Main phone: +41 58 792 9100
Mobile phone: +41 79 596 7211
Fax: +41 58 792 9354
mailto: sebastian.di.paola@ch.pwc.com

Question 8: "what is a Constant Maturity Swap?"

Submitted by Cindy Chan on 10/2/2009

The Doctor's Answer:

Dear Cindy,

In response to your question "what is a Constant Maturity Swap?" submitted through the Ask the Doctor section of TMI's website, here are some thoughts which I hope will help. Please feel free to contact me should you require further details on how such an instrument might be used by a corporate entity.

Regards
Sebastian.

A constant maturity swap, also known as Constant Maturity Swaq (CMS), is an interest rate swap where the rate of one leg is readjusted periodically based not on short term LIBOR as would normally be the case, but rather based on a longer term interest rate index (usually 2 to 5 years based on fixed rate products). In other words the constant maturity leg of the swap regularly refixes to a new long term rate, so it is variable, but based on long term rather than shrt term rates. The other leg of the swap may be either traditional LIBOR or fixed. The CMS allows the purchaser to fix the duration of receive (or pay) flows on a swap.

The primary difference between interest rate swaps and constant maturity swaps is that the floating leg of the former typically resets against a published index. Whereas the floating leg of the latter fixes againgst a particular point on the swap curve on a periodic basis.

CMS are therefore exposed to changes in long-term interest rate movements.

Example:
A company believes that the difference between the six-month LIBOR rate will fall relative to the three-year swap rate for a given currency. To take advantage of this, he buys a CMS paying the six-month LIBOR rate and receiving the three-year swap rate.

Who could use CMS?
- Investors or corporations attempting to take a view in the yield curve while seeking the flexibility that the CMS will provide
- Investors or corporations seeking to maintain a constant liability duration or constant asset duration.

Assessment

The advantages of CMS are:
- maintaining a constant duration
- not subject to the "point in time" with a DIRF (differential interest rate fix)
- that the user can determine "constant maturity" as any point on the yield curve
- that it can be booked similarly to an Interest Rate Swap

The disadvantages of CMS are:
- that it requires ISDA documentation
- that it suffers from the potential of unlimited loss


Sebastian di Paola
Partner
PricewaterhouseCoopers SA
Avenue Giuseppe-Motta 50
CH-1211 Geneva 2
Switzerland

Direct phone: +41 58 792 9603
Main phone: +41 58 792 9100
Mobile phone: +41 79 596 7211
Fax: +41 58 792 9354
mailto: sebastian.di.paola@ch.pwc.com

Question 7:

Please describe the risk and control policies in treasury business, including limits sanctioned against exposures in place, risk methodology, the sanctioning process?

Submitted by Georges Khoury on 29/8/2008

The Doctor's Answer:

The Risk and Control Policy is the primary governance document in Treasury and therefore has to be approved by the Board of Directors or senior management. The policy can be described as the guideline for Risk Management which defines the types of risk that are managed by treasury, the treasury approach, the roles and responsibilities, the risk measures as well as the controls around the activity. As a policy is typically high-level and only considers the major tasks most banks or corporations have additional documentation, such as manuals (e.g. detailed description of Value-at-Risk calculation) or job descriptions. Nevertheless, each policy depends on the type of risk and the business a bank or corporate runs. For instance, a retail bank has very different treasury requirements than an investment bank. However, in general, the policy document might consider the following matters:

Definition of the Risk (Market Risk, Credit Risk, Liquidity Risk, etc.)
Description of the risk and assessment of how the bank is affected by the risk

Roles and Responsibilities
In summary, which parts of the organisation are responsible for the risk management framework, limit setting, controlling, monitoring, etc. It is necessary to consider principles such as "Segregation of Duties", "Second Set of Eyes", etc. Typically, Board of Directors, senior management, committees and departments such as Trading, Risk Control are involved in the risk management process.

Limit Framework and Escalation
Subject to the risk, different limits are set up (e.g. exposure limits, counterparty limits, VaR limits, stress testing limits); if certain limits are breached, e.g. intraday or overnight, Risk Control triggers an escalation process. Depending on the type or importance of the limit, different parts of the organisation are involved in this escalation process until the limit is met again. If a limit on a trading desk is breached intraday, only the Head of Trading and Risk Control might be informed immediately whereas a VaR limit breach overnight is directly addressed to senior management and / or the members of the ALM-Committee (ALCO).

General Risk Methodology / Measures
Most policies also mention the type of risk methodology which is implemented and integrated in the regular reporting. Typically, banks use scenario analysis, VaR, expected shortfall, stress testing and other methodologies. As mentioned above more details are written in separate manuals which support the treasury policy framework.
Instrument coverage

For the management of market risk, policies also state what kind of products and currencies are authorized (e.g IRS, Forwards, USD, EUR, etc.).

To summarise, a policy has to be designed individually based on the type of business, size and risks a bank or corporation is exposed to. However, best practice requires that a number of matters, as mentioned above, are covered in the policy documents.

Question 6:

I am trying to hedge the FX risk for the company through forwards, but I am really worried about the accounting aspect, as if I did the forward hedging how can I show the offset if the forwards showed some losses? Is through re valuing the original cash flow I am hedging? and does both go through the income statement? The same also applies for interest rate swaps?

Submitted by Zaid Anani on 16/7/2008

The Doctor's Answer:

Thank you for your question, which is indeed a very valid one.

The first question I would have for you is which accounting standards your company reports under. If, as I assume is the case, this is either IFRS or US GAAP, then the accounting standards (IAS 39 and FAS 133) are complex, and the accounting depends very much on the nature of the hedged item. Put simply, we can say the following:

The basic treatment for derivatives (which includes FX forwards and interest rate swaps) is that these should be marked-to-market through P&L, as you describe in your note. The problem with this is that it leaves you with earnings volatility if your hedged expsoure is not also valued through P&L, which in most instances is not the case. To avoid this "accounting volatility" you can elect for hedge accounting. This is potentially complex and requires up front documentation and proof, at inception and ongoingly, of the effectiveness of each individual hedge.

If correctly documented, hedge accounting comes in two forms:

- Fair Value hedge accounting (generally applied for hedges of assets and liabilities which are alread on the balance sheet and, in the case of interest rate hedges, to hedges of fixed rate assets and liabilities swapped to floating) allows you to make a corresponding and opposite revaluation of the hedged item to offset, to some extent, the market value changes of the derivative.

- Cash Flow hedge accounting (generally applied to hedges of forecasted transaction and, in the case of interest rate hedges, to hedges of floating rate assets and liabilities swapped to fixed) alllows you to defer the gain or loss on the derivative in a separate component of equity (a hedging reserve), with recycling of these gains and losses to the P&L when the hedged expsosure affects P&L.

This is a very short explanation of a highly complex topic which has been a major challenge for treasurers around the globe. If you would like to know more, please feel free to contact me. My details are below. We have a huge amount of experience on helping companies with these issues and providing training to treasurers on this topic.

Question 5:

What is the Meaning of EIBOR?

Submitted by Mr Ravi on 21/4/2008

The Doctor's Answer:

The interest rate charged by banks in the United Arab Emirates for interbank transactions. In most cases, EIBOR is the reference rate most commonly used by borrowers and lenders to conduct financial transactions in Dubai and the surrounding Emirates.

Similar to the London Interbank Offered Rate (LIBOR), EIBOR futures contracts are available for trade and there are various EIBOR offered rates depending on the life of the loan.

Many Islamic banks use EIBOR rates as benchmarks for determining the rental rates for special leasing agreements called Ijara.

Question 4:

Can you please explain what Treasury Management is all about in layman's terms?

Submitted by Lekan Shodunke - Nigerai on 3/3/2008

The Doctor's Answer:

"Treasury management includes the management of cash flows, banking, money-market and capital-market transactions; the effective control of the risks associated with those activities; and the pursuit of best performance consistent with those risks. Treasury activities center on the organisation's use of capital and project financings, borrowing, investment, and hedging instruments and techniques.

In a nutshell its all about raising money, managing money  and protecting money from the various risks such as currency, commodity and interest rate."

Question 1:

What is the right amount of cash for your business?

Submitted by Mark Beard, Head of Liquidity and Investments, EMEA, Citi on 11/2/2008

The Doctor's Answer:

"Answering these questions is at the root of what we do. Measurement is not enough: acting on the results is what matters. As part of our research we have found that while variations in cash holdings occur due to different characteristics across industries, these variations are outweighed by differences within industries with companies having different degrees of cash effectiveness. Companies with greater cash effectiveness hold lower cash-to-sales ratios which in turn has an impact on profitability."

Mark Beard was interviewed by Helen Sanders in TMI 162, see our publication area for full article.

Question 2:

Where should companies start when it comes to benchmarking performance?

Submitted by Mark Beard, Head of Liquidity and Investments, EMEA, Citi on 11/2/2008

The Doctor's Answer:

Mark Beard, of Citi - "Although many treasurers have found it difficult to monitor and quantify their performance in the past, there are many things one can quantify . W e encourage clients to take a disciplined approach and focus on the areas which have the most impact on the financial performance of the business. In the cash management space, corporations typically measure things which have little impact on financial ratios and the balance sheet. For example, many US corporations focus on check float to try and increase DPO. This can have a disastrous effect on the predictability of cash flow . Predictability and volatility are the two factor s with the most significant impact on the balance sheet and the amount of funding companies need to source for their working capital.

We use various measures with our customers to determine how to reduce volatility and how to increase cash flow predictability in order to make inroads into the financial health of the company. A significant measure is to track cash holdings as a percentage of sales turnover, taking into account that this will differ across industries, which will have different cycles and velocity of cash flow. Rather than looking at cash holdings, treasurers are often monitored on the return on investment this is understandable, but it does not reward or penalise whether this cash should have been held in the first place. For example, we calculated for one US customer, which is typical in many respects, that while a cash centralisation project would create interest savings on short-term investments of $100,000, the balance sheet impact of aggregating cash and reducing the volatility of their cash needs was mor e in region of $60-$80 million."  see TMI issue 161 for full story