GET YOURSELF EXAM READY

The study guide for each unit of the Certificate in Treasury

has been written to help you achieve your qualification.

Focused syllabus coverage

Syllabus references showing where each syllabus
learning outcome is covered
Suggested study hours to guide your personal
study program
Practical examples to illustrate theory and concepts
Self-assessment exercises to reinforce your understanding
Direction to online resources including short
quizzes and further reading.

CERTIFICATE
ABOUT THE ACT
The ACT is the only international chartered body to set the benchmark for treasury excellence.

IN TREASURY
Our competency framework sets the standards for the skills, knowledge and behaviours treasurers,
or those working with treasurers, need at each stage of their career. Achievement of these standards
is measured and recognised by our globally delivered suite of qualifications.

The ACT Competency Framework defines The content of this syllabus introduces the skills
the key responsibilities, skills, knowledge required to operate at an operational level.
and behaviours needed to be effective when
working in or with the treasury profession. STUDY GUIDE: UNIT 1
It was developed in consultation with Strategic Level
practitioners from treasury, financial Managerial Level
services and learning and development.
To help you identify which competencies Operational Level
are relevant to you, we’ve mapped them to Tactical Level
4 job levels: tactical, operational, managerial
and strategic. This guide is aimed at
supporting those in managerial level roles. treasurers.org/competencyframework

FOLLOW US CONTACT US
@ACTupdate The Association of Corporate Treasurers
facebook.com/actupdate T +44 (0)20 7847 2529
E [email protected]
treasurers.org/linkedin
youtube.com/treasurersorg

academy.treasurers.org
First published 2016. Updated and republished 2020.

Published by: ACT (Administration) Limited www.treasurers.org

Copyright © ACT (Administration) Limited 2020.

All rights reserved. Except as permitted under current legislation you may not photocopy,
store in a retrieval system, publish, perform in public, adapt, broadcast, transmit, record or
reproduce in any form or by any means or medium any part of this work without ACT
(Administration) Limited's permission.
Nothing in this publication should be taken as constituting professional advice. Although we
have made every effort to ensure that the contents are correct at the time of publication, ACT
(Administration) Limited makes no warranty that the information in this publication is
accurate or complete and accepts no liability for any loss or damage suffered by any person
acting or refraining from acting as a result of anything in this publication.

Certificate in Treasury |
 CERTIFICATE IN
Treasury
Contents

Course guidance 1
Unit 1: The context of treasury 3

Study session 1: Treasury organisation and operations 5

1.1 The treasury function 6

1.2 The structure of treasury 10
1.3 The organisation and policies of a treasury department 19
1.4 Core treasury elements 27
1.5 Study session 1 exercises 33

Study session 2: Fundamentals of interest rate markets and

the process of discounting 42

2.1 Analysis using calculations 43

2.2 Interest rate market conventions 54
2.3 Yield and discount 65
2.4 The yield curve 75
2.5 The time value of money and discounted cash flow 85
2.6 Study session 2 exercises 95

Study session 3: Foreign exchange market fundamentals 121

3.1 The foreign exchange market 122

3.2 Foreign exchange market dealing conventions 127
3.3 Forward foreign exchange markets 134
3.4 Linking spot rates, interest rates and forward rates 143
3.5 Study session 3 exercises 150

Index 164

Certificate in Treasury |
 CERTIFICATE IN
Treasury
Course guidance
OVERVIEW
The Certificate in Treasury consists of five units that introduce a wide range of important
treasury subjects in broad detail:

 Unit 1: The context of treasury

 Unit 2: Cash and liquidity management
 Unit 3: Corporate finance
 Unit 4: Ethics, governance and regulation in treasury
 Unit 5: Risk analysis and management

The study material of each unit is arranged into manageable study sessions.
The Unit 1 Study Guide consists of three study sessions.

SYLLABUS AND LEARNING OUTCOMES

All ACT qualifications have their own syllabus which sets out what you need to learn to be fully
prepared to take your assessments.
The syllabus is broken down by unit and each unit has a set of learning outcomes which
describe what you should know, understand and be able to do by the end of the unit’s course.
You can use the syllabus as a checklist whilst you are learning and also when you come to
revise to make sure you have covered everything you need to know and assure yourself you
are ready for your assessment.
The complete syllabus for the Certificate in Treasury Fundamentals can be downloaded from
the ACT Learning Academy site in the course area of this qualification. Further hints and tips
on how to use the syllabus to help you study can also be found on the site.

STUDY RESOURCES
The Unit 1 Study Guide consists of:
 Course guidance: An overview of the course, study materials and study hours for the
Certificate in Treasury.
 Unit introductory guide: An overview of the Unit and its learning outcomes, as well as an
outline of its study sessions and the suggested study hours for each session.
 Study session guides: An overview of each study session and a list of its readings, exercises
and associated learning outcomes, as well as references to online-only resources.
 Readings: Each study session consists of readings with relevant learning outcomes
signposted throughout.
 Self-assessment exercises: Each study session concludes with a set of exercises that help
you assess your understanding of the learning outcomes covered in that study session.
Answers are provided along with a reference to the relevant learning outcome so you can

Certificate in Treasury | 1
 quickly determine which areas you may need to improve. Note: these are not exam-
standard questions – see the specimen paper for exam-standard questions.

Online-only resources
Online-only resources are available in the course area of the ACT Learning Academy site.
 Self-assessment progress tests: Each study session includes a short online multiple-choice
quiz that helps you assess your grasp of key concepts and are a good way to track your
understanding. Note: these are not exam-standard questions – see the specimen paper
for exam-standard questions.
 Specimen paper: An exam-standard sample paper with worked solutions to help you self-
assess your level of understanding in preparation for the assessment.
 Enhance and expand: Further resources for each study session are designed to enhance
and expand what you have learned in core readings and exercises.
 Glossary of terms: A glossary of terms, definitions and acronyms (your course syllabus
also includes a glossary of key unit terms used in the syllabus).
 Course syllabus: A complete guide to all the content you will need to learn and revise to
be ready for your assessments. It contains the learning outcomes (what you need to learn)
for each unit. Use the syllabus as a checklist during learning and revision to help you check
you have covered everything you need to.
 Webinars: Pre-recorded webinars to supplement this study guide and enhance your
learning. Look out for this icon and find your webinars on your course page.
 Podcasts: Key concepts re-capped in pre-recorded podcasts. Look out for this icon and
find your podcasts on your course page.

STUDY HOURS
The total suggested study time for the Certificate in Treasury course is 250 hours. Of those,
we recommend that you spend 50 hours revising for the assessment.
The suggested study time for Unit 1 is 50 hours:
 40 hours for the readings and exercises found in this Unit 1 Study Guide, as well as the
online self-assessment progress tests. The unit introductory guide provides details on how
much time we estimate you might spend on each study session.
 10 hours to be put towards revising for the assessment.

Extra resources are not factored into the suggested study time and are available as an online
resource to enhance and expand your learning only.
Note: These study hours are suggestions only. Different people have different levels of
background knowledge, learning styles and study habits. You will need to determine how
much time you need to take for your studies in order to do your best.

Certificate in Treasury | 2
 UNIT
1
The context of treasury
ABOUT THE UNIT
This unit establishes the context in which the treasury function operates and provides an
introduction to techniques which will underpin your future studies and your career.
The first part of the unit looks at how the treasury department is structured to support the
business in meeting its overall aims.
The second part of the unit will introduce you to two of the fundamental principles of finance:
interest rates and the time value of money. You will investigate some general aspects of
interest rates and how interest is calculated, which leads on to applications in the time value
of money and discounted cash flow analysis. These concepts will then be used to examine
practical treasury issues, for example, how interest rates vary with maturity, and what long-
term interest rates can tell us about future short-term rates.
The third and final section looks at the essentials of foreign exchange. It starts with a general
overview of the foreign exchange markets and then considers the mechanics of spot and
forward foreign exchange dealing. The final part of the unit examines the important
relationship between spot and forward foreign exchange rates.

LEARNING OUTCOMES
EXPLAIN THE ROLE OF THE CORPORATE TREASURY FUNCTION AND, IN PARTICULAR, HOW A TREASURY
DEPARTMENT IS STRUCTURED AND THE CONTROLS IN PLACE TO ENSURE ITS EFFECTIVENESS IN
SUPPORTING THE FINANCIAL AND RISK MANAGEMENT OBJECTIVES OF THE ORGANISATION.
 LO1 Discuss the role of treasury and how it can support the achievement of both short-
term and longer-term objectives of the organisation.
 LO2 Evaluate a range of appropriate treasury structures which reflect the risk appetite,
culture and financial objectives of the organisation.
 LO3 Outline the activities and controls required of a treasury department in order to carry
out its role successfully, avoiding operational errors, financial penalties or loss of
reputation.
 LO4 Describe how the role of the treasury function ensures that the key financial risks and
requirements of the organisation are identified and appropriately managed.

EXPLAIN AND APPLY A RANGE OF INTEREST RATES, YIELDS AND DISCOUNT RATES, UNDERTAKE
DISCOUNTED CASH FLOW ANALYSIS, DIFFERENTIATE BETWEEN DIFFERENT YIELD CURVES AND
UNDERTAKE RELEVANT YIELD CURVE CALCULATIONS.
 LO5 Explain why numerical analysis is essential to the function of treasury.
 LO6 Calculate the common types of interest rates and use them to compare short-term
borrowing costs and returns on short-term investments.

Certificate in Treasury | 3
 LO7 Calculate short-term yields, discount rates, redemption values and market prices to
enable appropriate comparisons between different short-term instruments.
 LO8 Examine the various yield curves, what they are used for and the relationships
between them, including calculations, to ensure the correct rates are used for given tasks.
 LO9 Calculate present values of single and multiple future cash flows in order to undertake
appropriate and accurate investment appraisal.

DESCRIBE THE FEATURES, PARTICIPANTS AND CONVENTIONS OF THE FOREIGN EXCHANGE MARKET IN
ORDER FOR THE ORGANISATION TO MAXIMISE THE VALUE OF ITS NET ASSETS AND MINIMISE FOREIGN
EXCHANGE RISK.
 LO10 Review the main features of, and participants in, the foreign exchange market in
order to understand how the market operates.
 LO11 Show how foreign exchange rates are calculated and used in order to meet the
needs of the organisation.
 LO12 Explain the principles and practicalities of forward foreign exchange contracts and
short-dated foreign exchange swaps and how they can be used by the organisation to
protect itself against basic types of foreign exchange risk.
 LO13 Evaluate the relationships between foreign exchange spot rates, forward rates, and
interest rates in related currencies, in order to identify any arbitrage opportunities or
mispricing in the rates quoted by market makers.

LEARNING STRUCTURE
STUDY SESSION 1: TREASURY ORGANISATION AND OPERATIONS
12 suggested study hours
– LO1, LO2, LO3, LO4

STUDY SESSION 2: FUNDAMENTALS OF INTEREST RATE MARKETS AND THE PROCESS OF DISCOUNTING
16 suggested study hours
– LO5, LO6, LO7, LO8, LO9

STUDY SESSION 3: FOREIGN EXCHANGE MARKET FUNDAMENTALS

12 suggested study hours
– LO10, LO11, LO12, LO13

Certificate in Treasury | 4
 STUDY SESSION
1
Treasury organisation and
operations
CORE RESOURCES AND LEARNING OUTCOMES
These are the learning materials for this study session, with the relevant Unit 1 learning
outcomes that are addressed in the materials.
1.1 The treasury function
LO1 Discuss the role of treasury and how it can support the achievement of both short-
term and longer-term objectives of the organisation.
1.2 The structure of treasury
LO2 Evaluate a range of appropriate treasury structures which reflect the risk appetite,
culture and financial objectives of the organisation.
1.3 The organisation and policies of a treasury department
LO3 Outline the activities and controls required of a treasury department in order to carry
out its role successfully, avoiding operational errors, financial penalties or loss of
reputation.
1.4 Core treasury elements
LO4 Describe how the role of the treasury function ensures that the key financial risks
and requirements of the organisation are identified and appropriately managed.
1.5 Study session 1 self-assessment exercises
Exercise questions that test the learning outcomes of this study session.

Study session 1 self-assessment online progress test: Don’t forget to try the multiple-
choice online quiz to assess your grasp of key concepts.

ENHANCE AND EXPAND

To access further material designed to enhance and expand what you have learned in
this study session, login to your course and look for this study session’s online resources.

Certificate in Treasury | 5
 READING
1.1
The treasury function
1 INTRODUCTION
This reading introduces a number of concepts that will underpin your future studies and
career.
Corporate treasury is a profession built on the foundation of a number of financial disciplines,
all of which are vital in their own right and also support and complement each other.
Many companies or organisations will have an employee with the title, treasurer, in much the
same way as they may have a company secretary or a financial controller. Even where no
dedicated role exists, someone in the organisation will almost certainly be undertaking the
role as a part of their job.
In a company which consists of a large group of international businesses, a treasurer’s role
becomes broader, for instance managing centralised treasury operations for the group’s
subsidiaries worldwide. In some companies’ treasurers also have a more general responsibility
for risk management. This can include management of the insurance function and sometimes
management of a company’s obligations with respect to tax and relationships with the
relevant tax authorities. Some treasurers also take part responsibility for the company’s risks
arising from pension funds of which it is the sponsor. The treasurer’s responsibilities could
also include being available to help pension scheme trustees to understand some of the
related issues they have to deal with.
The role and structure of treasury is driven by the overarching objectives of the underlying
business and so it is imperative that the treasury function understands and operates in
support of the business.
This reading looks at the main objectives of a treasury and how a treasury department is
structured to support the business in achieving its objectives.

LO1 Discuss the role of treasury and how it can support the achievement
of both short-term and longer-term objectives of the organisation.

2 THE STRUCTURE OF THE FINANCE FUNCTION

The three functions of financial management are: treasury, corporate finance and financial
control. Figure 1 shows how a finance department is often set up and the main tasks each
function is responsible for managing. In a large organisation the responsibilities will be carried
out by individuals or departments; in smaller organisations the responsibilities may be shared
among one or two individuals.

Certificate in Treasury | 6
Figure 1: The finance function

3 THE ROLE AND RESPONSIBILITIES OF THE FINANCE DIRECTOR, FINANCE

DEPARTMENT AND TREASURER
Since most commercial decisions are ultimately measured in financial terms, it is not
surprising that financial management plays a vital role in the operation of the organisation.
The size and importance of the finance function depends on a number of factors, such as the:
 size of the organisation
 nature of its business
 capabilities of those responsible for financial management
 capabilities and financial awareness of other key managers and directors of the business.

3.1 THE FINANCE DIRECTOR AND FINANCE DEPARTMENT

As an organisation grows, the importance of the finance function typically results in the
evolution of a separate finance department – an independent organisational unit linked to
the chief executive or board of directors through the finance director (FD).
The finance director manages the finance department. Finance director is an equivalent role
to chief financial officer (CFO).

3.2 THE ROLE OF THE TREASURER

The treasury function within a company is responsible for managing its financial assets and
liabilities. This normally includes the management of:
 cash
 funding and liquidity
 credit
 banking relationships
 financial risk
 foreign exchange.

Certificate in Treasury | 7
The focus is on the risks that threaten the group’s financial assets and the cash flows
associated with both assets and liabilities, and on the efficiency with which risks are mitigated.

4 OBJECTIVES AND ROLE OF A TREASURY DEPARTMENT

Although treasury is a relatively new function, it has evolved significantly since its origins. The
primary, and original, task of treasury was once narrowly defined as ‘ensuring the company
can pay its debts as they fall due’, i.e. cash and liquidity management. Over time, however,
that definition has expanded so that ensuring liquidity is now seen in the broader context of
underpinning the longer-term financial viability of the business. Treasury has increasingly
become a financial risk management function irrespective of the size, complexity or culture
of the organisation.
‘Treasury’ is a broad term relating to managing the financial health of an organisation. Its
primary aim has traditionally been to preserve existing cash funds and financial assets by:
 ensuring liquidity (ultimately access to cash), in order to meet all current and future
liabilities
 ensuring that business activities are funded in the most appropriate and cost effective
manner
 identifying and managing financial risks which could erode financial strength
 developing and encouraging a culture of sound financial practice.

Someone in every business does this role, and thus is responsible for ‘treasury’ whether the
organisation is a large quoted group, a professional firm such as solicitors, or a business owned
privately by families, individuals or private equity organisations.
The key treasury tasks include:
 identifying, assessing, evaluating and managing the financial and other risks to the
organisation
 assisting or leading the organisation’s enterprise-wide risk management function
 managing the company’s capital structure and weighted cost of capital
 identifying an appropriate risk management strategy in light of the organisation’s stated
treasury policy.

In order to provide the organisation with effective risk management support, treasury must
have a deep understanding of the underlying business.

How treasury supports the objectives of an organisation

Most business decisions are ultimately measured in financial terms. For this reason financial
management plays a vital role in the operation of the organisation.
Treasury is a key part of the financial management of the organisation.

Certificate in Treasury | 8
5 THE OBJECTIVES OF THE ORGANISATION AND THE ROLE AND ACTIONS
OF TREASURY
In most cases, treasury’s role is defined by the characteristics of the organisation, such as:
 size and complexity of the organisation
 nature of business
 industry of operation and stage of development
 country of domicile of the parent company and subsidiaries
 nature and domicile of investors
 nature and size of the risks facing the organisation
 level of international versus domestic business
 credit strength of the organisation
 experience of the treasurer
 corporate history, culture and organisation
 life cycle/stage of development of the individual business.

The role of the treasurer depends very much upon the individual business and the type of
organisation. So, for example:
 an engineering company may require a specialist in long-term financing, with taxation
skills
 a retail or consumer organisation might need a treasurer with transactional skills, such as
those required to negotiate with transportation companies
 a manufacturing business might require working capital expertise, for example to
accelerate the process of collecting money owed by customers
 An organisation operating globally might emphasise international cash management
skills.

6 SUMMARY
In this reading you have been introduced to the role of treasury within an organisation, and
how it can support the achievement of both short-term and longer-term objectives of the
organisation. You have looked at:
 how a typical organisation structures its finance function
 the responsibilities of the finance director, the finance team and the treasurer
 the key objectives of a treasury department
 the linkages between the underlying business and the role and actions of treasury.

Certificate in Treasury | 9
 READING
1.2
The structure of treasury
1 INTRODUCTION
There are many factors that determine the most appropriate structure and organisation of
treasury.
In practice these factors may conflict and may need to be reconciled or compromised. This
reading will explore these issues for a variety of treasury contexts.

LO2 Evaluate a range of appropriate treasury structures which reflect the

risk appetite, culture and financial objectives of the organisation.

2 FACTORS AND FINANCIAL OBJECTIVES INFLUENCING THE STRUCTURE

OF TREASURY
These factors include the size and international scope of the business and its trade, together
with the level of financial risk, especially debt, as well as the culture of the business. These
factors, with others, will also dictate how the treasury function might be structured.
This reading considers the role of treasury by looking at treasury from three different
perspectives or dimensions as summarised in Figure 1. By observing treasury from each
perspective, we gain an understanding of how the treasury function operates within the
organisation as a whole.
These dimensions of treasury are interdependent and overlap. For instance, profit centre
treasuries are more likely to be centralised and to act as in-house banks.

Certificate in Treasury | 10
Figure 1: Finance and treasury structure

3 THE ROLE OF TREASURY WITHIN AN ORGANISATION

Depending on how an organisation chooses to structure itself, treasury’s role will be different
in each scenario.
There are three main treasury roles, or management styles, reflecting an increasing degree of
centralisation of execution, and perhaps also (but not necessarily) policy making.
These are advisory, agency and in-house banking.

3.1 ADVISORY
In a decentralised organisation, treasury often comprises a small group of specialists located
at head office. They act as advisors to the organisation. Treasury’s authority may vary, from
pure advice which divisional finance managers can ignore if they wish, to having the authority
to set corporate policy, and therefore effective control over the overall direction of treasury
activity.
Examples of areas where the advisory treasury may be involved include:
 setting treasury policies and objectives
 establishing treasury reporting and monitoring systems
 acting as a central source of financial markets information
 managing the treasury requirements of the head office.

In this case there is very little legal interaction, in the form of transactions, between the
central treasury and the subsidiaries, although it is likely that there will be some intercompany
loans used to fund the subsidiaries or to extract their surplus cash. Subsidiaries transact
predominantly with local banks, although it is possible under this model for transactions to be
with an in-house bank, acting simply like an external bank.

Certificate in Treasury | 11
3.2 AGENCY
In a more centralised operation, treasury may undertake an agency role where the day-to-day
treasury decisions are still made at local level by operational management, but the execution
is centralised to obtain efficiencies and economies of scale. This means that when a decision
is taken at the local level about what transaction is required, it will be referred to central
treasury to carry it out. The treasury unit therefore acts as an agent of the local management
units.
The effect of this arrangement is that the central treasury unit manages external relationships,
including banking, for all the operating subsidiaries in the group.
The advantage of having a central treasury perform this function is that it should be possible
to obtain improved rates and prices through centralised dealing and relationship
management. Treasury specialists are employed to manage the group’s treasury transactions.
Transactions between the central treasury and the subsidiaries are again predominantly via
intercompany loans. However, whilst central treasury will initiate trades, the associated cash
flows with the central relationship banks are usually via the many subsidiary bank accounts,
unless an in-house bank is involved. This can quickly become confusing.

3.3 IN-HOUSE BANK

With this type of arrangement, the central treasury acts as an internal bank for the group with
which all the subsidiaries deal. Business decisions are still taken by local management
at subsidiary level, but as far as possible banking services are provided by the central treasury.
This includes transactions for hedging risk exposures.
The central treasury, like an external bank, charges for its banking services. Also like an
external bank, having entered into transactions with its client subsidiaries, it can then decide
what hedging measures are needed to cover its own, i.e. the group’s positions within the
group’s policy framework.
The main reason for using an in-house bank is to reduce group banking costs by:
 aggregating external transactions and dealings for borrowing, investing and foreign
exchange in order to achieve better rates
 reducing the number of external banks and bank accounts overall
 minimising the number of transactions made through external banks. For example,
intercompany payments will be cashless transactions passed over the accounts of the in-
house bank.

4 RISK APPETITE AND CULTURE AND THEIR IMPACT ON TREASURY’S

STRUCTURAL RESPONSE TO RISK
Another way to look at the role of treasury is to consider the treasury function’s response to
risk. Treasury’s response to risk will be influenced by factors such as risk appetite, as defined
in board policy, competitive position and industry practice, as well as the competencies to
assess risk and manage it effectively.
A risk-averse board with a passive response to risk will usually prefer a cost centre approach
to treasury, whereas a board with a preference for accepting risk and an active response to
risk will tend to favour a profit centre response.

Certificate in Treasury | 12
4.1 COST CENTRE
The cost centre response sees treasury as a service centre. Treasury activity is designed to
ensure the efficient utilisation of cash, and to minimise the impact of financial volatility.
The advantage of this approach is that it enables commercial decisions to be taken against a
reasonably certain financial background. The disadvantage is that there are few incentives for
the treasurer to be innovative in approach, or to consider how treasury activity can add value
to the group.

4.2 COST SAVING CENTRE

The cost saving centre response is sometimes called a value-added treasury. Like a cost centre
response, it sees treasury as primarily a service function whose role is to minimise financial
volatility.
However, treasury activity is assessed by how much value is added to the group, rather than
captured within the department alone. So, for instance, the introduction of an efficient cash
pooling structure would be assessed against quantitative and qualitative criteria to determine
what benefits had been captured for the group.

4.3 PROFIT CENTRE

The profit centre response sees treasury as a line function rather than a support function. This
may involve allocating to treasury the value it adds to the group through activities
that might also be undertaken within a cost saving centre, such as cash management activity.
However, it may also, within clear guidelines, include a more active approach to risk
management. An active approach to risk management necessarily includes additional risks,
and therefore requires greater treasury skill, clear policy guidelines, and a rigorous control
environment.
Where speculative trading is undertaken by a corporate, perhaps in a commodity where it has
a strong market presence, this is usually undertaken outside treasury.

5 TREASURY AUTHORITY
The internal organisation of treasury reflects the business organisation and the requirements
of the different roles described in Figure 1. The key issues from this perspective are related to
the distribution of authority and execution capability across the various levels of the
organisation.
The main broad choice is between centralisation and decentralisation. The more centralised
the organisation, the more authority will be reserved for, and exercised by, central functions
rather than locally.
As companies become larger, authority in treasury matters has tended to become more
centralised in the interests of financial efficiency and control, and potentially at the expense
of local motivation and alignment of treasury policy with local business needs.
A decision to centralise treasury operations tends to create a structure that provides sufficient
scope for specialisation. Within treasury, there may be separate departments to manage such
activities as cash management, insurance, tax, and funding.

Certificate in Treasury | 13
5.1 CENTRALISED TREASURY STRUCTURES
Centralisation is supported by two major developments:

Technology
Enterprise resource planning (ERP) systems, treasury management systems (TMSs) and
internet capabilities mean that even smaller organisations can contemplate using centralised
structures such as payment factories, shared service centres and in-house banks.

Regulatory environment
Under Sarbanes-Oxley and similar regulations, organisations need increasingly to
demonstrate good governance. Treasurers of international organisations need to find
structures that will give them greater control over treasury activities.
Advances in technology, pressure on costs, the need to manage risk and the emphasis on
corporate governance, have all led to greater centralisation of many treasury functions. This
trend is generally accompanied by extensive involvement in funding and acquisition.
No matter how compelling the financial arguments in favour of centralisation, however, there
can be many reasons why organisations choose to remain wholly or partially decentralised.
Centralisation or decentralisation is not an either/or decision. Organisations can find
themselves anywhere along a spectrum from one extreme to the other, with some elements
centralised and others not.
Figure 2 illustrates how treasuries can be organised along two major axes – policy making and
execution.

Figure 2: Degrees of centralisation

Other factors in favour of centralisation include single financial status, synergy of expertise,
cost saving and improved control.

Single financial status

When bankers, investors or creditors provide funds to a company, it is often based on an
assessment of the continuing financial health and viability of the entire organisation. Even if
the funds are being provided to a subsidiary, it is normal practice to assess subsidiaries as
extensions of the parent company. Therefore, as the outside world assesses the organisation
and all of its subsidiaries as a single entity, it makes a lot of sense to manage the finances
centrally.
Certificate in Treasury | 14
Synergy of expertise
Good treasurers are hard to find. As a consequence, an argument can be made that the limited
number of quality treasury personnel should be gathered at a central location. The benefit of
this is that more sophisticated analysis and operations can take place than if the knowledge
were spread geographically throughout the organisation.

Cost saving
Cost efficiencies can accrue to an organisation by centralising treasury. These efficiencies
occur in two ways:

 by reducing the need for (more expensive) treasury staff in various locations, and
 a single treasury operation can reduce costs through netting of cash positions internally
as well as by lower commissions on outside deals through increased buying power.

Control
A centralised treasury has much improved control over cash, funding and exposures. Rogue
dealing by subsidiaries should be minimised, and management of the group’s funding is not
only better controlled but also simplified.

Drawbacks
The drawbacks to centralising treasury are also persuasive. First, the trend towards identifying
profit centres within an organisation implies that those in charge of these units should also be
in charge of their finances. By centralising treasury, the profit centre manager cannot be said
to operate a self-contained business and hence, to be entirely accountable for its
performance. (The in-house bank concept can address this issue.)
An in-house bank will also achieve many of the benefits associated with centralisation.
Second, in geographically dispersed organisations, there are often unique local circumstances
that must be adhered to when considering financial arrangements. This is particularly true
when treasury operations are required in countries where foreign exchange regulations
restrict international transfers.

Example 1: BT Centralised treasury

The group has a centralised treasury operation whose primary role is to manage liquidity,
funding, investment and the group’s financial risk, including risk from volatility in currency and
interest rates and counterparty credit risk. The treasury operation is not a profit centre and
the objective is to manage risk at optimum cost.
The Board sets the policy for the centralised treasury operation and its activities are subject
to a set of controls commensurate with the magnitude of the borrowings and investments
under its management. Counterparty credit risk is closely monitored and managed within
controls set by the Board. The group does not hold or issue derivative financial instruments
for trading purposes. All transactions in financial instruments are undertaken to manage the
risks arising from underlying business activities.
(BT 2007)

Certificate in Treasury | 15
5.2 DECENTRALISED TREASURY STRUCTURES
A corporate decision to maintain a decentralised treasury operation rarely means that all
treasury activities are spread among group companies. Normally, head office retains some
overall treasury functions such as setting policy guidelines, monitoring operating unit
performance and enforcing procedures.

Figure 3: An example of a centralised treasury structure

The point behind a decentralised treasury is to allow each operating business within the group
the responsibility and flexibility to manage its own particular treasury requirements. By closely
aligning treasury operations to the specific needs of each business unit, it is anticipated that
treasury requirements can be more precisely met.
The advantages of a decentralised treasury function include local autonomy, local needs and
saving head office costs.

Local autonomy
Efficient and profitable treasury operations need to take into account local financial market
conditions as well as the cash and funding requirements of the business. By being more closely
aligned with the local financial scene through local bank managers, treasury operations should
be enhanced.

Alignment of treasury policy with local needs

Organisations which operate in a wide variety of product markets often find that it is
necessary to set guidelines that support the strategic issues in each business. As a
consequence, in areas such as cash management, banking and taxation, head office can
provide relatively little added value.

Head office costs are reduced

Decentralisation does not often occur solely to the treasury function. It is normally part of an
initiative to decentralise all support functions, such as human resource management, sales
and marketing, and purchasing. The benefit to the group is simple: to reduce group overheads,
although costs and headcount will rise at a local level instead.

Certificate in Treasury | 16
Drawbacks
The drawbacks to a decentralised approach include:
DUPLICATION
As each profit centre will require some treasury operation, there will be significant replication
of similar activities across the entire range of subsidiaries, resulting in higher local staffing
costs.
LOSS OF ECONOMIES OF SCALE
The financial clout of dealing in larger volume may be lost as each profit centre maintains and
arranges its own financial requirements.
NEED FOR SUITABLY QUALIFIED STAFF
Staff must be recruited, trained and inculcated with the corporate ethos. They also have to be
relied on absolutely to implement policy consistent with the needs of the centre.
Decentralisation makes this more challenging to achieve.
LOSS OF CONTROL
Decentralised treasuries require excellent systems and communication in order to retain
control.

Figure 4: A typical decentralised treasury structure

Another significant variable when evaluating the benefits and disadvantages of centralised or
decentralised treasury is the increased potential for speculative treasury operations. If each
subsidiary is a profit centre, there may be a tendency to speculate through its treasury
operations if operational profits are low.
This increased appetite for risk can have serious negative consequences if not handled
properly. Therefore, one of the most important activities of group treasury is to maintain a
watchful eye on the nature and extent of the treasury activity undertaken in each profit
centre.

Certificate in Treasury | 17
Dynamic balance
Historically, the trend was to centralise authority. However, some organisations that are
pursuing global spread and therefore have a greater variety of environments to manage are
beginning to push some discretion back down to subsidiary level.
This seems to be partly a response to size and complexity, and partly a desire to make
subsidiary managers more aware of how their financing and risk management activities feed
through to shareholder value.
This decentralisation recognises that there is usually some degree of sharing of responsibility
between the centre and subsidiaries. The centre of gravity of authority will move between the
centre and subsidiaries on the basis of a continuing dialogue about which party is best suited
to make particular decisions.
This approach is sometimes known as ‘dynamic balance’.

6 SUMMARY
In this session you have considered a range of possible treasury structures which might be
appropriate for an organisation, depending on its risk appetite, culture and financial
objectives. You have looked at:
 multiple factors influencing the structure of treasury
 the key roles of treasury, e.g. advisory, agency and in-house bank
 issues of risk appetite and appropriate treasury risk response
 cost centre, cost saving centre and profit centre approaches to managing treasury risk
 the advantages and disadvantages of centralised and decentralised treasury
structures.

ENHANCE YOUR UNDERSTANDING

Now that you have completed this reading, review the podcasts and webinar to enhance
your understanding. The podcasts and webinar are accessible from your course page.

Certificate in Treasury | 18
 READING
1.3
The organisation and policies of a
treasury department
1 INTRODUCTION
There are many t ways in which a treasury can be organised, but within the scope of tasks to
be performed there are certain key roles which do not vary. Depending on the size of the
organisation, some staff may perform more than one role.
In creating a treasury structure, the aim is to ensure that:
 agreed objectives are met
 activities are undertaken within policies approved at board level
 activities are conducted in a controlled manner
 activities are supported with accurate reporting.

Significant differences can be observed between countries in their approach to treasury.

However, the underlying principles when establishing a treasury organisation, particularly
those around policy, controls and systems, are applicable in any environment.

LO3 Outline the activities and controls required of a treasury department

in order to carry out its role successfully, avoiding operational errors,
financial penalties or loss of reputation.

2 THE ACTIVITIES AND PROCESS FOR UNDERTAKING TREASURY DEALS

Most corporate treasury deals can be analysed into the process elements shown in Figure 1.

Figure 1: Treasury processes

2.1 CONTROL AND REPORTING

These process elements tend to follow in sequence, except for control and reporting, which
is a continuous process throughout the cycle. There are certain activities and tasks that are
typically included at each stage. Remember that not all corporate treasuries will carry out all
Certificate in Treasury | 19
these tasks, or give them equal weight. Priorities will be strongly influenced by the liquidity
positions and risks generated by the core business.

2.2 ANALYSIS, DECISION MAKING, EXECUTION, APPROVAL, SETTLEMENT AND ACCOUNTING

The terms ‘front office’, ‘middle office’ and ‘back office’ are often used to describe these
processes. This derives from banking practice, where traditionally the execution (front office),
approval and validation (middle office) and settlement and accounting functions (back office)
are separated into different locations, as well as organisationally.
Within the corporate treasury environment, the bank middle and back office functions are
usually carried out within the corporate back office and where a corporate middle office exists
it will perform quite a different function. Most treasuries will have a front and a back office;
only larger firms have a separate middle office.
Treasury departments vary in scale and organisational structure, according to the size and
complexity of the business. In smaller companies, treasury responsibilities are sometimes
undertaken by just one person, or another finance department. In a large, complex,
international business, however, it is likely to involve a number of staff, who might be
professional managers, such as a regional treasurer, or specialists in particular treasury
activities, such as foreign exchange dealers or investment managers.

3 FRONT OFFICE, BACK OFFICE AND MIDDLE OFFICE ROLES

3.1 FRONT OFFICE
The front office executes transactions, interfaces with the group’s entities and has the most
interaction with external financial counterparties. It is responsible for:
 implementing the strategy approved by the board
 working with the business to identify risks within the organisation, e.g. foreign exchange
exposures
 decision making and execution of agreed deals in permitted instruments within risk limits
 accurate and timely recording of deals.

Roles that may be found in the front office include:

 dealers – transact with external banks; work with the business to identify exposures
 risk manager – managing interest rate, foreign exchange risk
 funding manager – with responsibility for long-term funding, e.g. bond issuance, bank
facilities
 treasury operations manager – oversees activities of the dealers.

3.2 BACK OFFICE ROLES

The back office administers and supports the front office and its main functions are to
validate, settle and account for deals. Support and administrative staff form the back office.
They are responsible for:
 ensuring that deals have been accurately recorded by the front office
 ensuring that deals meet internal policies and guidelines
 ensuring that deals have been confirmed by counterparties
 validating processes
 managing a deal’s life cycle through to maturity, i.e. to settlement
 accounting
Certificate in Treasury | 20
 controlling and reporting on dealing activity
 monitoring controls and providing assurance to management that dealing and treasury
activities generally are fully and properly carried out and controlled, if no separate middle
office function exists.

3.3 MIDDLE OFFICE ROLES

Some corporate treasuries, typically in larger firms, separate control and compliance activities
into a separate function, and may term this the middle office. ‘Compliance’ in this context
normally refers to compliance with internal guidelines, rather than external regulations. In
this case, rather than approval and validation as found in a bank, the middle office is
responsible for:
 the design and maintenance of a control framework, including regular reports to
management on its integrity and efficiency
 treasury reporting and management information
 systems development.

The control function may have a reporting line directly to the group or corporate treasurer, to
the chief financial officer, or to the head of the central accounting department. In any case,
there will be a strong ‘dotted line’ relationship to internal audit.

3.4 SKILLS NEEDED TO SUCCESSFULLY FULFIL THESE POSITIONS

The competencies required to create an efficient treasury function are diverse.

Front office
Dealers must be numerate and familiar with financial market practices and procedures. They
must understand the instruments available, and their advantages and disadvantages.
Additionally they should be able to recommend which are appropriate for particular
circumstances. Increasingly, dealers are required to be familiar with sophisticated pricing and
modelling tools and techniques.

Back and middle office

Administrative staff, i.e. back office and middle office, also need to be familiar with the
instruments traded and their associated market practices, in order to understand the
instruments that they are administering. They will focus strongly on processes and controls
and timely identification of discrepancies and be familiar with the systems that support these
activities. They require sufficient familiarity with accounting concepts to support the treasury
accounting function, whether or not this is organisationally part of treasury. Large complex
treasuries increasingly have a member, or members, of the team dedicated to the
development and monitoring of the control framework.

Management
Management needs to be familiar with company policy, structures and procedures. It requires
an understanding of markets, instruments and practices that is adequate to participate in the
decision-making process and also to advise business units and executive management on
matters of policy, process and control. Management is generally dependent on the back and
middle office team for the quality of reports received.

Certificate in Treasury | 21
Accounting
Accountants need to have a working knowledge of financial markets, instruments and risk
management in order to manage an increasingly complex financial reporting environment. As
a general principle it is difficult to manage or control a process that is not understood.
It is, therefore, essential that all treasury staff are properly trained and regularly update their
skills.

4 CONTROLS AND SEGREGATION OF DUTIES

Treasurers deal with large sums of money on a daily basis and the key operational risks to
manage are those of fraud and error. Segregation of duties, usually achieved by the split of
the treasury into front office and back office, is a key management control designed to reduce
the risk of error or fraud.
Segregation of duties is sometimes referred to as the ‘duality’ or ‘four eyes’ principle. A good
definition of the principle is that no employee should be in a position both to commit and to
conceal fraud or errors in the usual course of duties. Duties that should be segregated include:
 control over valuable assets, e.g. ability to make payments
 authorisation or approval of transactions that affect those assets, e.g. the ability to
execute transactions
 recording or reporting of such transactions, e.g. accounting for transactions.

The objective is to involve several people in the life of a single deal, from initiation, through
transacting, to settlement and reporting in order to minimise the risk of fraud, which would
require collusion on a large scale to be successful and undetected errors slipping though.
A typical treasury transaction would involve the steps illustrated in Figure 2.

Figure 2: A typical treasury transaction process

The first three of these steps will be undertaken in the front office, and the last three or four
steps undertaken in the back office.
As a minimum, even in the smallest company, the same individual should not undertake both:

 a front and a back office role

 pre-dealing authorisation and dealing in the front office
 the initiation and authorisation of settlement in the back office
 accounting and any other back office function.

As further levels of control:

 It is preferable for the people who make up the front and the back office to have different
reporting lines.
 Appropriately trained junior staff may legitimately perform tasks necessary to achieve a
segregation of duties but they should not check the work of those to whom they report.

Certificate in Treasury | 22
The growing use of systems in the treasury function means that IT can be used as an additional
control mechanism, for example by automatically confirming transactions with the third party
almost instantly after execution, by restricting settlement of funds to pre-defined bank
accounts and by flagging exceptions to management.
Poor management control can sometimes result in the compromise of the segregation of
duties. This exposes both the firm and treasury staff members to unacceptable risks.

Example 1: Heriot-Watt University segregation of duties policy

The University considers it essential for the purposes of the effective control and monitoring
of its treasury management activities, for the reduction of risk of fraud or error, and for the
pursuit of optimum performance, that these activities are structured and managed in a fully
integrated manner, and that there is at all times clarity of treasury management
responsibilities. The principle on which this will be based is a clear distinction between those
charged with setting treasury management policies and those charged with implementing and
controlling these policies, particularly with regard to the execution and transmission of funds,
the recording and administering of treasury management decisions, and the audit and review
of the treasury management function.
The Director of Finance will ensure that there are clear written statements of the
responsibilities for each post engaged in treasury management and the arrangements for
absence cover. The Director of Finance will also ensure there is proper documentation for all
deals and transactions, and that procedures exist for the effective transmission of funds.
(Heriot-Watt University 2015)

5 OUTSOURCING TREASURY ACTIVITIES

Outsourcing involves sub-contracting work to an external organisation as a service provider.
There are a number of reasons why organisations may consider outsourcing part or all of the
treasury functions including:

 lack of specialist skills in-house

 more efficient, lower cost processing of transactions
 freeing up more time for strategic decision making
 saving the high costs of keeping up with technology advances.

What functions should be outsourced?

‘Core competencies’ of the organisation should rarely be outsourced. Core competencies are
those business activities in which, relative to other organisations, the organisation has
superior competence, from which it can therefore generate added value.
Part of an organisation’s core competencies is the capacity and skill to make strategic
decisions. Such decisions should not be outsourced, since taking such decisions is the job of
the board. Examples of strategic decisions would include strategic funding or investment
decisions.
Business critical functions, sometimes called strategic functions, may or may not be core
competencies. A business critical function is one where the failure of that function would
seriously jeopardise the capacity of the firm to operate and therefore many companies would
choose not to outsource them. In theory, as some functions such as IT, human resources, or

Certificate in Treasury | 23
treasury, may be critical but not core, they may be outsourced if value can be added by doing
so.
Outsourcing of non-core competencies may take place either on a functional or a regional
basis. For instance, under a functional outsourcing arrangement the management and front
office functions, such as funding, interface with group entities and deal execution may be
retained in-house, while back office and systems functions such as reconciliation and
reporting are outsourced.
The decision on what to outsource comes down to who can add most value to which functions.
If there is value added in-house, on whatever basis this is measured, it should be retained. In
other situations, a specialised treasury provider can add more value, and those functions are
the ones best suited for outsourcing. However, treasurers tend to be reluctant to adopt full
outsourcing solutions, preferring to limit their use to processing activity.

Example 2: Treasury outsourcing

More treasury systems are being implemented in the cloud, either as a pure Software as a
Service (SaaS) application or as a private cloud on dedicated client databases. This trend has
been driven by cost and security with the prevailing view being that outsourcing IT
infrastructure and security to dedicated vendors is cheaper and more efficient than installing
systems in-house.
(EY 2018)

6 TREASURY POLICY
Treasury policy is a mechanism by which the board, or management, can delegate
fundamental financial decisions about the business in a controlled manner. It should give
treasury staff written guidelines on what they are responsible for, how they should go about
their responsibilities, what their boundaries are and how their performance will be measured.

6.1 KEY CONTENTS

For each type of risk, the treasury policy should contain and explain:

 what the risk is and why it is being managed, taking into account the company’s risk
appetite
 risk management objectives
 risk measures to be used in measuring risk and risk management performance
 benchmarking routines
 the delegation of responsibility for managing risk
 actual procedures to be followed
 risk targets and limits based on an acceptable level of risk
 performance reporting and feedback mechanisms.

Certificate in Treasury | 24
6.2 APPROVAL
The board has the ultimate responsibility for risk management and is responsible for
approving risk policies.
However, the board cannot conduct risk management on its own. Typically, the board allows
the day-to-day management of risk to be delegated to responsible individuals. Nevertheless,
the board should still ensure, via strict controls, that any delegated goals are actually achieved
within the centrally mandated guidelines.

6.3 IMPLEMENTATION
In many larger companies, risk management tasks are delegated to a sub-committee of the
board, usually called the risk management committee (RMC) – or an equivalent name. The
RMC is made up of selected board members together with senior managers. Its exact
composition will depend on the business and its sector, but typically might include the chief
financial officer, the corporate treasurer, the operations director, a non-executive director,
the compliance officer and perhaps also the chief executive. The RMC is focused on enterprise
wide risks and not just financial risks.
Strategic elements of the financial risk management strategy will be set by the board, e.g.
what markets to enter, whether to grow the business organically or by acquisition, what
financing profile best supports the business. Tactical elements are typically delegated to the
CFO or treasurer, e.g. selection of counterparties, timing of action in the markets, selection of
borrowing instruments to support the business.

6.4 REVIEW
The role of an RMC is to establish an overall risk management direction, a clear vision for risk
management that is supported by policies and operating principles. However, ultimate
responsibility for risk management and approval of policy remains with the board.
Where possible, the same committee that develops the financial risk management policy
should also set up the policy towards commercial, legal or other risks and this will often be
the RMC. Many risks interact, some risks may reinforce each other, while others mitigate the
effects. For example, commercial risks may have implications for financial risks and vice versa.
Managing risk on such an integrated basis is the concept that underpins enterprise-wide risk
management or ERM.
Objectives and strategies for risk management are designed to complement the organisation’s
existing vision and goals and the RMC should embody the corporate culture towards risk.
The RMC should meet periodically to review the state of the organisation’s exposures or to
consider new situations that need senior management attention or decisions. On a more day-
to-day basis, or week to week, the monitoring and maintenance roles can be delegated to
more specialist committees, addressing different functional areas of risk management.
Group treasury is then responsible for the day-to-day operation of the treasury function
within the agreed limits and policy guidelines. Group treasury is also responsible for reporting
exposures and performance to the RMC.

Certificate in Treasury | 25
 Example 3: James Fisher Plc – Role of the board in setting treasury policy
James Fisher's internal control and risk management framework is regularly monitored and
reviewed by the Board and the Audit Committee and comprises a series of policies, processes,
procedures and organisational structures which are designed to ensure that the level of risk
to which the Group is exposed is consistent with the Board’s risk appetite and the Company’s
strategic objectives.
The Board determines the Group’s policies on risk, appetite for risk and levels of risk tolerance
and specifically approves: risk management policies and plans; significant insurance and/or
legal claims and/or settlements; acquisitions, disposals and capital expenditures; and the
Group budget, forecast and three year plan.
The Board has put in place a documented organisational structure with strictly defined limits
of authority from the Board to operating units that have been communicated throughout the
businesses and are well understood by the Executive Directors, functional and business
leaders who have delegated authority and specific responsibility for ensuring compliance with
and implementing policies at corporate, divisional and business unit level. Group functions
and operating units are each required to operate within this control environment and in
accordance with the established policies and procedures covering areas including ethical, anti-
bribery and corruption, conflicts, treasury, employment, slavery and human trafficking,
whistleblowing, data protection, health and safety and environment.
(James Fisher 2018)

7 SUMMARY
In this reading you have looked at the activities and controls required of a treasury
department that enable treasury to carry out its role successfully and to avoid operational
errors, financial penalties or loss of reputation, including:
 the process for undertaking treasury deals including the analysis, decision making,
execution, approval, settlement and accounting implications of a deal
 front office, back office and middle office roles and the skills needed to successfully
fulfil these positions
 segregation of duties
 outsourcing treasury activities
 treasury policy including key contents, approval process, implementation and review.

Certificate in Treasury | 26
 READING
1.4
Core treasury elements
1 INTRODUCTION
The treasury function has evolved substantially over time. The primary, and original, task of
treasury was narrowly defined as ‘ensuring the company can pay its debts as they fall due’,
i.e. cash and liquidity management.
Over time, however, that definition has expanded so that ensuring liquidity is now seen in the
broader context of underpinning the longer-term financial viability of the firm. Treasury has
increasingly become a financial risk management function irrespective of the size, complexity
or culture of the organisation.

LO4 Describe how the role of the treasury function ensures that the key
financial risks and requirements of the organisation are identified and
appropriately managed.

2 OPERATIONAL AND STRATEGIC FUNCTIONS OF TREASURY

The core responsibilities of treasury include:

 cash and liquidity management

 corporate financial management
 capital markets and funding
 risk management (typically with a focus on financial risk management)
 treasury operations and controls.

In the past, treasury’s main role centred on cash management and its fundamental task was
‘to ensure that the business could pay its bills as they fell due’, in other words, ‘to ensure
liquidity’. As businesses became international, and as financial markets were liberalised and
became more sophisticated, treasury took on new roles. Probably the most significant of
these is the management of financial risk, particularly the risks associated with the volatility
of foreign exchange rates and interest rates.
The treasury function is responsible for managing the organisation’s financial assets and
liabilities. This includes the management of cash, funding and liquidity, credit, banking
relationships, financial risk and foreign exchange. The focus is on the risks that threaten the
group’s net financial assets and the cash flows associated with both assets and liabilities; and
on the efficiency with which risks are mitigated.

Certificate in Treasury | 27
Figure 1: Treasury responsibilities

The treasurer carries a dual role that is both strategic and operational. While being responsible
for the operational functions, the treasurer usually also manages the channels (treasury
systems, operations and control) through which they are delivered.

3 CASH AND LIQUIDITY MANAGEMENT

Cash and liquidity management is concerned with the organisation’s cash resources and its
access to them. This means ensuring cash is available to meet day-to-day and longer-term
commitments. The key treasury tasks include:

 ensuring that at all times cash is available in the right place, at the right time, and in the
right currency
 maintaining sufficient committed borrowing facilities, on the right terms to provide the
organisation with the cash it needs, when it needs it
 safeguarding and maximising the value of all short-term financial assets

3.1 CASH MANAGEMENT

Cash management generally refers to the physical movement of cash, so that the business can
make payments as they fall due. Because of payments and receipts in transit, the cash balance
in the books of a firm may differ from the bank’s balance. It is the bank’s cleared balance that
is available to spend, not the firm’s balance.
Cash management is a subset of liquidity management, and is traditionally defined as
covering:
Day-to-day cash control Monitoring bank account balances and managing liquidity.
Bank account structure Structuring bank accounts to minimise borrowing costs and
maximise interest earned.
Collections Maintaining an efficient collection system.
Payments Making payments efficiently.
Short-term investment Optimising the use of surplus funds.
Short-term borrowing Procuring cost effective short-term credit facilities.
In addition to these core functions, depending on the business, it is quite common to find the
cash manager also being involved in:
 medium- and short-term cash flow forecasting
 netting of settlements between subsidiaries, divisions, or trading partners
 cross-border liquidity management
Certificate in Treasury | 28
 trade finance including bank guarantees, bills of exchange and letters of credit
 receivables management
 payables management
 selecting and implementing systems enhancements.

3.2 CURRENCY MANAGEMENT

For many reasons, an organisation may need to engage in foreign exchange transactions. At
its simplest level, this may be the immediate purchase or sale of a foreign currency, i.e. not
the currency in which the organisation normally operates. Alternatively, the business may be
trading in the forward or futures markets where trades that are fixed today will not settle for
many days, weeks, months or even years. Foreign currency management will take place in the
context of the firm’s financial risk management policies, as developed from its risk
management framework.

3.3 LIQUIDITY MANAGEMENT

Liquidity management refers to ensuring that the organisation has access to cash to pay
current and future obligations as they become due. This includes having access to sufficient
borrowing facilities, or to liquid assets that can be converted to cash easily,and using
techniques that enable organisation-wide liquidity management.
Liquidity management is the most fundamental element of treasury risk management. If it
fails, the organisation cannot continue to operate and all other decisions, no matter how
important, are irrelevant.
As such, every aspect of the work of the treasurer interfaces with liquidity management. Cash
management, working capital management, organising and managing borrowing facilities and
short-term investments are the key tools for managing short-term liquidity. Corporate finance
and capital markets and funding are the key tools for managing longer-term liquidity. Risk
management and treasury operations and controls are necessary components of both short-
term and longer-term liquidity management.

3.4 ANALYSIS OF WORKING CAPITAL

Working capital analysis is an essential component of liquidity management. This is the
understanding and management of the cash absorbed by, or released from, the organisation’s
investments in net current assets or liabilities.

4 CORPORATE FINANCIAL MANAGEMENT

Corporate financial management is the practice of developing strategies and plans, and
making investment decisions that positively affect the value of the corporate.
The key tasks include:

 minimising the organisation’s weighted average cost of capital (WACC) through

appropriate capital structuring and the use of tax efficient instruments and markets
 providing a complete, accurate and valid contribution to the organisation’s external
reporting
 ensuring that the organisation is fairly evaluated by investors
 ensuring that the organisation provides investors with returns commensurate with the
risks investors take on.

Certificate in Treasury | 29
4.1 CORPORATE FINANCE
Although setting policy is primarily the responsibility of the finance director, the treasurer is
involved in arranging funding, and in the detailed evaluation of mergers and acquisitions. The
treasurer will also be involved in the detailed technical evaluation of divestments, project and
investment appraisal and business developments.

4.2 INVESTMENT MANAGEMENT

Management of both short- and long-term investments is a key treasury responsibility. Short-
term investment management forms part of the cash management treasury function. Longer-
term investment management is generally covered under the corporate financial
management function of treasury, where funds may be set aside for capital investment
purposes.

5 CAPITAL MARKETS AND FUNDING

There are two forms of funding that give an organisation a longer-term financial platform, i.e.
its capital structure, on which to build its business. These are equity in the form of share capital
and borrowings in the form of loan capital.
The treasurer can strongly influence, and is usually primarily responsible for, the financing of
the organisation’s activities. This could include raising bank loans, funding from bond markets,
or equity from existing or new investors.
The key treasury tasks include:

 sourcing finance efficiently from private and public markets

 ensuring borrowing terms are consistent with the organisation’s credit standing and with
its business objectives
 developing new sources of funds by investigating structures, providers and markets.

Developing excellent long-term relationships with potential providers of finance and

communication in good time with lenders and investors are essential.
A fundamental principle of sourcing capital is to do so well in advance of the need for the
capital becoming pressing. Avoid approaching the market when clearly in need of funds.

5.1 FUNDING MANAGEMENT

This involves arranging debt finance, which may come from banks or public markets, as well
as the ancillary facilities needed for foreign exchange dealing and cash management.
Typically, the treasurer manages the mechanisms by which funding is raised in terms of debt
instruments, maturity, currency and interest basis, and negotiates the terms on which
facilities are provided or capital markets debt is issued.
The treasury department also deals with the documentation and day-to-day management of
the relationship with the loan provider. The treasurer may also be involved in the raising of
equity capital.

5.2 BANK RELATIONSHIP MANAGEMENT

Arising from the responsibility for funding, this function is different from those already listed,
because it may not result in financial transactional activity. It can almost be regarded as the
treasury department’s public relations function.

Certificate in Treasury | 30
This role is sufficiently important that some large firms employ a dedicated senior treasury
professional to keep its funders, e.g. banks, shareholders, bondholders, etc. properly
informed of its current position and activities and to provide a focal point for bank
negotiations and selection. This area may also manage the relationship with credit rating
agencies, although this activity is so important to some organisations that it is kept with the
treasurer personally.

6 FINANCIAL RISK MANAGEMENT

Risk management is the identification, analysis and management of the financial and other
risks to which an organisation is exposed. It is about the identification, assessment, evaluation,
management and reporting of those risks that could damage an organisation’s financial
health.

6.1 A BASIC RISK MANAGEMENT FRAMEWORK

The treasurer is involved in setting risk management policy and managing risks against that
policy. Historically, treasury risk management normally referred to three main types of
financial risk: foreign exchange risk, interest rate risk and liquidity risk. However, in many
organisations treasury’s risk management role has been expanded to adopt an enterprise-
wide approach to risk management and include commodity, insurance, pensions, operational
and credit risk.
The key treasury tasks include:
 identifying, assessing, evaluating, and managing the financial and other risks to the
organisation
 assisting or leading the organisation’s enterprise-wide risk management function
 minimising the organisation’s weighted cost of capital
 determining an appropriate risk management strategy in light of the organisation’s stated
treasury policy.

In order to provide the organisation with effective risk management support, treasury must
have a deep understanding of the underlying business.

6.2 GENERAL RESPONSES TO RISK

These may be classified broadly as:

Organisational responses
At the structural level, treasury may be organised broadly as a cost centre, a cost saving centre
or a profit centre. Cost centres are the most risk-averse organisational response to risk. Profit
centres are the most risk tolerant.

Operational responses
Moving to the operational level, general risk responses may be classified broadly as:
 avoid
 accept and retain
 accept and reduce
 accept and transfer.

Avoidance is the most risk-averse operational response. This generally means declining the
opportunity to undertake the relevant business.
Certificate in Treasury | 31
Accept and retain is the most risk-tolerant. This means accepting business and managing the
related risks in-house, usually where they are part of the core competencies of the
organisation.

7 TREASURY OPERATIONS AND CONTROLS

It is a complex managerial assignment to carry out all the varied tasks in such a way that they
are completed on a consistent basis, without disrupting or contradicting each other.
For this to happen, the treasurer must be able to balance continually shifting priorities and
always be aware of the wider business and financial environment. Managing the treasury
function is about being in tune with the aims of the organisation and its investors, being in
control of financial processes and taking responsibility for important but difficult decisions.
The key treasury tasks include:

 maintaining an appropriate treasury departmental structure to coordinate and deliver all

its objectives
 managing treasury resources efficiently and effectively
 developing policies and procedures to support the organisation’s risk management
framework
 developing reporting processes and controls appropriate to policy and procedures
 facilitating optimal corporate governance structures and outcomes for the firm.

Corporate governance is an essential backdrop to all these tasks. The treasurer must ensure
that the highest levels of integrity are maintained throughout the treasury function, not only
individuals working in treasury but also processes, procedures and systems.

8 RELATIONSHIP MANAGEMENT WITH KEY INTERNAL AND EXTERNAL

STAKEHOLDERS
The key dimensions of relationship management are communication and timing. It is essential
for the treasurer to develop excellent long-term relationships with all stakeholders, including
a reputation for frankness and timely disclosure of relevant information. It is particularly
important to forecast accurately all fund capital requirements well in advance, avoiding the
need to approach the markets from a position of weakness or any potential financial distress.
The treasurer must build high levels of behavioural and business competencies to fulfil this
essential role successfully.

9 SUMMARY
In this reading you have seen the role treasury plays in ensuring that the key financial risks
and requirements of the organisation are identified and appropriately managed. You have
looked at:
 the operational and strategic functions of treasury
 the main features of corporate financial management
 fundamental aspects of cash, liquidity and funding management
 risk management and responses to risk
 importance of managing relationships with key internal and external stakeholders.

Certificate in Treasury | 32
 SELF-ASSESSMENT
1.5
Study session 1 exercises
Use these exercise questions to assess your understanding of the learning outcomes of
this study session.

You should also try this study session’s online progress test which is a short multiple-
choice test designed to assess your grasp of key concepts.

QUESTIONS
QUESTION 1
LO1
You are the recently-appointed treasurer of the Mega group of companies.
Identify three ways in which you can support the group’s objectives of preserving its cash and
financial assets.

QUESTION 2
LO1
In your role as a company treasurer, identify three key treasury tasks.

QUESTION 3
LO1
Describe briefly how treasury can support the achievement of the objectives of a commercial
organisation.

QUESTION 4
LO2
You are advising the group treasurer of the Ace group, which is considering centralising
treasury functions. Which of the following benefits usually result from centralising treasury
functions?
Improved control Staffing levels can be Better knowledge of subsidiary
reduced businesses

a) Yes Yes Yes

b) Yes Yes No

c) Yes No No

d) No Yes Yes

e) No No Yes

f) No No No

Certificate in Treasury | 33
QUESTION 5
LO2
You are the newly-appointed assistant group treasurer at the Boles Corporation. Treasury
acting in an advisory role is likely to:
Manage external Publish treasury policies for Act as a central source
relationships the organisation of information
a) Yes Yes Yes
b) Yes Yes No
c) Yes No Yes
d) No Yes Yes

QUESTION 6
LO2
Your finance director seeks your advice about treasury organisation. Identify for the finance
director the main differences between cost centre, profit centre and cost saving treasuries.

QUESTION 7
LO2
For the benefit of a newly-appointed chief executive, who does not have a finance
background, outline the main advantages of centralising the treasury function of a firm.

QUESTION 8
LO2
Wayne Enterprises Inc. is a global organisation specialising in the design and manufacture of
eco-friendly food packaging. The newly-appointed treasurer is reviewing the existing
decentralised treasury structure and would like your input. Produce a concise board paper,
reviewing the appropriateness of a decentralised treasury structure for a global organisation
such as Wayne Enterprises Inc.

QUESTION 9
LO2
Stark Industries plc has recently appointed an intern who has queried the use of an in-house
bank. In your role as the intern’s mentor, briefly explain the characteristics on an in-house
bank and why some organisations such as Stark Industries use such a structure.

QUESTION 10
LO3
You are treasurer of Grossauto GmbH, a road haulage organisation with extensive
international operations, which has grown rapidly in recent years.
You have two people working for you, both unqualified treasurers.
One downloads data on the cash position each day and gives you the data.
One administers bank mandates, accounting records and some trade finance matters.
Payments and transactions in support of operations are made by whoever has the least
amount of work on.

Certificate in Treasury | 34
You have been authorised by the finance director to recruit a ‘dealer’, a new position
increasing the total staff to four.
What impact will the new recruit have on the organisation of Grossauto’s treasury?
In answering this question you should consider the organisation’s current situation, the key
roles in treasury, and how the recruitment may provide opportunities to improve how the
treasury department is run and organised.

QUESTION 11
LO3
You are the treasurer of Halo BV, which needs to appoint a suitably experienced new member
for its front office team. Which of the following tasks would be classed as ‘front office’?
a) decision making and execution
b) validation processes
c) settlement and accounting
d) control and reporting
QUESTION 12
LO3
You are mentoring a newly-appointed recruit to your treasury department, who is unclear
about the roles of the front office, middle office and back office. The front office should be
primarily responsible for:
a) ensuring counterparties confirm a deal
b) recording the deal accurately
c) after dealing, checking the deal was within risk limits
d) managing the deal through its life cycle
QUESTION 13
LO4
For the benefit of your newly-appointed assistant, list four of the five core responsibilities of
treasury.

QUESTION 14
LO4
For the benefit of a non-executive director, briefly explain four of the five core responsibilities
of treasury.

QUESTION 15
LO4
In relation to four of the five core responsibilities of treasury, outline two key treasury tasks
for the benefit of a newly-recruited member of the treasury team.

QUESTION 16
LO4
You are treasurer of Petitauto SA which specialises in the manufacture of small and
economical vehicles with mostly domestic operations in Europe.
It has been decided that the company should establish a presence in Latin America (LATAM),
where rising income has created a demand for more cars, with economical cars now being
particularly sought after.
Certificate in Treasury | 35
Your treasury in Europe is very centralised and is currently only involved in managing the cash
and the one bank facility used by the company.
What impact will the expansion into Latin America have on treasury?
For each of the five core treasury responsibilities consider what treasury does now and the
extra roles it may have to perform in the expanded group.

ANSWERS
ANSWER 1
Any three from:
 ensuring liquidity (ultimately access to cash), in order to meet all current and future
liabilities
 ensuring that business activities are funded in the most appropriate and cost effective
manner
 identifying and managing financial risks which could erode financial strength
 encouraging a culture of sound financial practice.

ANSWER 2
Any three from:

 identifying, assessing, evaluating and managing the financial and other risks to the
organisation
 assisting or leading the organisation’s enterprise-wide risk management function
 optimising the company’s weighted cost of capital (for example through reducing risk and
hence investor’s required rates of return)
 identifying an appropriate risk management strategy in light of the organisation’s stated
treasury policy.

ANSWER 3
Most commercial decisions are ultimately measured in financial terms.
For this reason financial management plays a vital role in the operation of the organisation.
Treasury is a key part of the financial management of the organisation.
Treasury supports financial management by ensuring liquidity and appropriate and cost-
effective funding, managing financial risk and encouraging a culture of sound financial
practice.

ANSWER 4
(b) Control is usually improved through the use of better IT and better-qualified staff.
Staffing levels are usually lower, since duplication is reduced.
However, the detailed knowledge of treasury staff concerning the business of the subsidiaries
is more likely to reduce, because of distance and time lags in communication.

ANSWER 5
(d) When treasury acts in an advisory role, external relationships will be managed locally, not
by treasury. The other statements are correct.

Certificate in Treasury | 36
ANSWER 6

Cost centre
A cost centre treasury acts as a service centre. It hedges operational exposures, at a cost.

Profit centre
A profit centre treasury may actively create market positions with a view to earning profits,
as well as hedging.

Cost saving centre

Cost saving centres are a more risk-tolerant variant on pure cost centres.
A cost saving centre treasury – like a cost centre treasury – acts primarily as a service function.
However, cost saving centre treasuries are allowed a degree of discretion about when to
hedge, with a view to reducing net costs.
They are sometimes also known as value-added centre treasuries.

ANSWER 7
The advantages of centralisation include:

Single financial status

When bankers, investors or creditors provide funds to an organisation, it is often based on an
assessment of the continuing financial health and viability of the organisation as a whole. Even
if the funds are being provided to a subsidiary, it is normal practice to assess subsidiaries as
extensions of the parent organisation. Therefore, as the outside world assesses the
organisation and all of its subsidiaries as a single entity, it makes a lot of sense to manage the
finances centrally.

Synergy of expertise
Good treasurers are hard to find. As a consequence, an argument can be made that the limited
number of quality treasury personnel should be gathered at a central location. The benefit of
this is that more sophisticated analysis and operations can take place than if the knowledge
was spread geographically throughout the organisation.

Cost saving
Cost efficiencies can accrue to an organisation by centralising treasury.
These efficiencies occur in two main ways:
 by reducing the total number of treasury staff, and
 a single treasury operation can reduce external costs through netting of cash positions
internally, as well as by lower commissions on outside deals through increased ‘buying
power’.

Control
A centralised treasury has much improved control over cash, funding and exposures.
‘Rogue dealing’ by subsidiaries should be minimised, and management of the group’s funding
is not only better controlled but also simplified.

Certificate in Treasury | 37
ANSWER 8
The advantages of decentralisation include:

Local autonomy
Efficient and profitable treasury operations need to take into account local financial market
conditions as well as the cash and funding requirements of the business. By being more closely
aligned with the local financial scene through local bank managers, treasury operations should
be enhanced.

Alignment of treasury policy with local needs

Organisations which operate in a wide variety of product markets often find that it is
necessary to set guidelines which support the strategic issues in each business. As a
consequence, in areas such as cash management, banking and taxation, there is relatively
little added value which head office can provide.

Head office costs are reduced

Decentralisation does not often occur solely to the treasury function. It is normally part of an
initiative to decentralise all support functions such as human resource management, sales and
marketing, purchasing, etc.
The benefit to the group is simple: to reduce ‘group overheads’, although costs and head
count will rise at a local level.

ANSWER 9
With this type of arrangement, the central group treasury acts as an internal bank for the
group, with which all the subsidiaries deal. Organisation decisions are still taken by local
management at subsidiary level, but as far as possible banking services are provided by the
central treasury. This includes transactions for hedging risk exposures.
The central treasury, like a bank, charges for its banking services. Also like a bank, having
entered into transactions with its client subsidiaries, it can then decide what hedging
measures are needed to cover its own (i.e. the group’s) positions, within the group’s policy
framework.
The main reasons for using an in-house bank include:
 reducing group banking costs by:
 aggregating and netting external transactions and dealing for borrowing, investing
and foreign exchange to achieve better rates
 reducing the number of banks and bank accounts overall
 minimising the number of transactions made through external banks (e.g.
intercompany payments will be cashless transactions passed over the accounts of the
IHB)
 reducing overall costs by decreasing the number of treasury staff and having one centre
of excellence
 improving skill levels by investing in staff in the centre of excellence
 optimising organisation-wide liquidity by using surplus cash to reduce borrowings
 enhancing control through transparency of entire liquidity position by:
 having electronic access to all bank accounts
 improving visibility of transactions and other information.

Certificate in Treasury | 38
ANSWER 10
First, consider the current situation. Grossauto has extensive international operations but
appropriate segregation of duties is apparently lacking. This is exposing both the organisation
and staff to considerable risk and is not acceptable. Current treasury staffing (three heads)
might be adequate to support the segregation of critical duties, but probably only if other
non-treasury staff are involved as well.
The recruitment of a dealer (and expanding the department by 33 percent) should be used to:
 implement effective segregation of duties between front and back office functions, and
to ensure the processes of authorisation of deals and settlement are carried out by other
people
 build ‘front office’ skills by focusing a specialist on that area
 relieve the treasurer of day-to-day dealing duties and allow him to focus on management
review and supervision of the team.

Holiday and sickness cover will probably still need the use of suitably qualified and
experienced staff from outside treasury.

ANSWER 11
(a) Decision making and execution.
The other activities are all middle office or back office responsibilities.

ANSWER 12
(b) Recording the deal accurately.
Dealers must be responsible for recording their own deals.
Dealers should check risk limits before dealing, not afterwards.
The other activities are middle or back office responsibilities.

ANSWER 13
Any four of:

 corporate financial management

 capital markets and funding
 cash and liquidity management
 risk management
 treasury operations and controls.

ANSWER 14
Any four of:

 corporate financial management is the practice of developing strategies and plans and
making investment decisions that positively affect the value of the corporate.
 capital markets and funding are concerned with the strategic funding of the organisation.
 cash and liquidity management is concerned with the organisation’s cash resources and
its access to them (liquidity). This means ensuring cash is available to meet day-to-day and
longer-term commitments
 risk management is the identification, assessment, evaluation, management and
reporting of those risks that could damage an organisation’s financial health

Certificate in Treasury | 39
 treasury operations and controls are about managing the treasury function appropriately.
This includes being in tune with the aims of the organisation and its stakeholders, being
in control of financial processes and taking responsibility for important but difficult
decisions.

ANSWER 15
For each area of treasury responsibility you have identified, any two tasks from those noted
below.

Corporate financial management

 minimising weighted average cost of capital through appropriate capital structuring and
the use of tax efficient instruments and markets
 providing a complete, accurate and appropriate contribution to external reporting
 ensuring that the organisation is fairly evaluated by stakeholders
 ensuring that the business provides stakeholders with returns commensurate with the
risks that they take on.

Capital markets and funding

 sourcing finance efficiently from private and public markets
 ensuring borrowing terms are consistent with the organisation’s credit standing and with
its strategic objectives
 developing new sources of funds.

Cash and liquidity management

 ensuring that at all times cash is available in the right place, at the right time, and in the
right currency to meet the payment obligations of the organisation when they fall due
 maintaining sufficient committed borrowing facilities on the right terms to provide the
organisation with the cash it needs when it needs it
 safeguarding and maximising the value of all cash available to the organisation.

Risk management
 identifying, quantifying and optimising the financial risks to the organisation
 assisting or leading the organisation’s enterprise-wide risk management
 minimising the organisation’s weighted cost of capital through reducing risk and hence
capital investors’ required rates of return
 determining an appropriate risk management strategy in light of the organisation’s
treasury policy.

Treasury operations and controls

 maintaining an appropriate treasury departmental structure to coordinate and deliver all
its objectives
 managing treasury resources efficiently and effectively
 developing policies and procedures to support the organisation’s risk management
framework
 developing reporting processes and controls appropriate to policy and procedures
 facilitating optimal corporate governance structures and outcomes for the organisation.

Certificate in Treasury | 40
ANSWER 16
The table considers Petitauto’s treasury’s current position and what roles treasury may have
to perform in the expanded group.
Taking the five core responsibilities in turn:
Role Current position Extra roles
a) Cash and Now undertaken Treasury must consider how cash will be managed
liquidity for Europe alone, country by country in LATAM, and will have to deal
management with no foreign in a variety of currencies. There may be surplus funds
currency issues. in LATAM, particularly during any build phase as
funds are pre-positioned pending their investment.
b) Capital Not carried out. How to fund the expansion.
markets and
funding
c) Corporate Not carried out. The investment in operational assets will need to be
financial appraised. Returns from LATAM must be monitored
management to ensure they meet investors’ expectations.
d) Risk Not carried out. To understand the business fully and deal especially
management with the financial risks of foreign exchange, liquidity
and interest rate risk for each country.
e) Treasury Currently Thought will be needed as to the structure and
operations centralised. control issues associated with treasury’s expanded
and controls role, in relation to LATAM time differences, etc.

This shows that the expansion will have a substantial effect on treasury. It will challenge
treasury’s centralised structure as the organisation has become considerably more complex.

Certificate in Treasury | 41
 STUDY SESSION
2
Fundamentals of interest rate
markets and the process of
discounting
CORE RESOURCES AND LEARNING OUTCOMES
These are the learning materials for this study session, with the relevant Unit 1 learning
outcomes that are addressed in the materials.
2.1 Analysis using calculations
LO5 Explain why numerical analysis is essential to the function of treasury.
2.2 Interest rate market conventions
LO6 Calculate the common types of interest rates and use them to compare short-term
borrowing costs and returns on short-term investments.
2.3 Yield and discount
LO7 Calculate short-term yields, discount rates, redemption values and market prices to
enable appropriate comparisons between different short-term instruments.
2.4 The yield curve
LO8 Examine the various yield curves, what they are used for and the relationships
between them, including calculations, to ensure the correct rates are used for given
tasks.
2.5 The time value of money and discounted cash flow
LO9 Calculate present values of single and multiple future cash flows in order to
undertake appropriate and accurate investment appraisal.
2.6 Study session 2 self-assessment exercises
Exercise questions that test the learning outcomes of this study session.

Study session 2 self-assessment online progress test: Don’t forget to try the multiple-
choice online quiz to assess your grasp of key concepts.

ENHANCE AND EXPAND

To access further material designed to enhance and expand what you have learned in
this study session, login to your course and look for this study session’s online resources.

Certificate in Treasury | 42
 READING
2.1
Analysis using calculations
1 INTRODUCTION
The ability to undertake clear and rigorous analysis of financial information is an essential
competency for all treasurers. This includes an appropriate level of numerical skills. How
happy would you be to entrust your money to a person who was not financially numerate?
This reading refreshes and sharpens key numerical techniques for essential treasury analysis.

LO5 Explain why numerical analysis is essential to the function of treasury.

2 ANALYSIS AND INTERPRETATION OF DATA

A common and important example of treasury data is interest expense and its forecasting.

2.1 EXPRESSING FINANCIAL RELATIONSHIPS IN EQUATIONS

We need to build a model of the relationship between the related financial amounts. For
example, in the case of interest expense:
interest expense = average borrowings × periodic interest rate
Applying this model to an interest forecast:
Say average forecast borrowings are EUR 100m, and the expected periodic interest rate is 2%
(= 0.02).
The forecast interest expense is given by:
EUR 100m × 0.02
= EUR 2.00m

Sensitivity analysis
A model of this kind enables sensitivity analysis to answer questions like:

 What would happen if borrowings were greater than expected

 What would happen if interest rates moved against us?

Sensitivity tables
We can vary either or both of our two inputs, and produce forecast figures for a range of
different out-turns.

Certificate in Treasury | 43
Figure 1: Interest expense sensitivity (EURm)

2.2 FINDING UNKNOWN ITEMS: SOLVING EQUATIONS

Say our complete budgeted interest expense is EUR 2m, and the expected periodic interest
rate is 2.5% (= 0.025).
To what figure must we manage our average borrowings, in order to meet our budgeted
interest expense of EUR 2m?
Rearranging our interest expense model:
expense = average borrowings × periodic interest rate
Using letters:
expense = B × r

Rearranging an equation
To rearrange an equation, do the same to both sides of it.
Here, divide both sides by r:
expense = B × r
expense/r = (B × r)/r
expense/r = B
B = expense/r
= EUR 2m/0.025
= EUR 80m

Target closing borrowings

To meet budgeted interest expense of EUR 2m, we need to manage average borrowings to a
figure of EUR 80m.
Opening borrowings were EUR 100m.
To what level do we need to reduce closing borrowings, to achieve average borrowings of EUR
80m?

Certificate in Treasury | 44
Set up and solve an equation
To model this, we need to make a simplifying assumption. We assume that the reduction in
borrowings progresses evenly. This means the average balance can be modelled as:
average = (opening + closing)/2
We need to rearrange this into the form:
‘closing balance = ’
We rearrange it by doing the same to both sides:
average = (opening + closing)/2
80 = (100 + closing)/2
Multiply both sides by 2:
80 × 2 = ((100 + closing)/2) × 2
80 × 2 = 100 + closing
160 = 100 + closing
Subtract 100 from both sides
160 – 100 = 100 + closing – 100
60 = closing
We need to manage down closing borrowings to EUR 60m
The principle of doing the same to both sides also works to solve more complex equations.

3 MONITORING CASH FLOW

Numerical analysis is essential to monitor and forecast cash flow, and ensure liquidity.

EXAMPLE 1
You are the treasurer of C GmbH (C).
Forecast cash flow, before interest expense, is EUR 10m.
Expected interest expense is EUR 2.5m
Calculate C’s expected cash flow after interest.
Solution
Cash flow after interest:
10 – 2.5
= EUR 7.5m

Certificate in Treasury | 45
4 FORECASTING NEED FOR FUNDS
Forecasting often involves multiple periods. For example, you may enjoy generally positive
regular cash inflows, but have a large one-off outflow in a single future period.
Will existing borrowing capacity be enough to cover this outflow?
There are two structures to support clear analysis and understanding here:
 table layouts, with columns by period
 cumulative balances, adjusted by the net flows in each period.

Figure 2: Duo SA cash flow and funding forecast (EURm)

Duo SA needs EUR 2m of funding to cover the cumulative deficit at the end of Period 2.
The opening balance for each period is equal to the closing balance of the previous period.
The opening balance in the Total column, EUR 0m, is the same as the opening balance for
Period 1 and not a sum of the opening balances.

5 FORECASTING RETURN ON INVESTMENTS

The cash return on an investment is the product of the cash amount or other value at the start
of the investment period, multiplied by the rate of return per period.
Assuming an investment of cash:
cash return = start cash × r
Where:
r = periodic rate of return
For example, if USD 100m is invested at a periodic rate of return of 2% (0.02), the cash return
is:
USD 100m × 0.02
= USD 2m

Certificate in Treasury | 46
5.1 TOTAL CASH AT END OF INVESTMENT
The total cash or other value at the end of an investment period is given by, assuming a cash
investment:
end cash = start cash × (1 + r)
For example, if USD 100m is invested at a periodic rate of return of 2%:
end cash = USD 100m × (1 + 0.02)
= USD 102m.
This total amount is of course the repayment of the original investment of USD 100m,
together with the cash return, or surplus, of USD 2m.

5.2 CALCULATING RATES OF RETURN

Treasurers often need to calculate rates of return from given cash flows, for example, the
starting amount and the end amount of an investment.
Assuming a single investment period, the relationship would be:
end cash = start cash × (1 + r)
Re-arranging this relationship to calculate the periodic rate of return (r):
end cash = start cash × (1 + r)
Divide both sides by the start cash:
end cash/start cash = (start cash × (1 + r))/start cash
end cash/start cash = 1 + r
Subtract 1 from both sides:
(end cash/start cash) – 1 = 1 + r – 1
(end cash/start cash) – 1 = r
r = (end cash/start cash) – 1

EXAMPLE 2: Periodic rate of return for a single period

a) Investment A gives EUR 102m at the end of one period for an investment of EUR 100m.
Calculate the periodic rate of return.
Solution
Periodic rate of return:
r = (102/100) – 1
= 2%
b) Investment B gives EUR 100m after one period for an initial investment of EUR 98m.
Calculate the periodic rate of return.
Solution: r = (100/98) – 1 = 2.0408%

Certificate in Treasury | 47
5.3 RATES OF RETURN AND GROWTH RATES FOR MULTIPLE PERIODS
The longer we have to wait to get our invested money back, the lower the rate of return per
period.
For multiple periods, the rate of return or growth rate per period is given by:
r = (end cash/start cash)(1/n) – 1
Where n = number of periods

EXAMPLE 3: Periodic rate of return and growth rate for multiple periods
Investment C gives EUR 102m at the end of two periods for an initial investment of EUR 100m.
Calculate the periodic rate of return.

Solution
The periodic rate of return is given by:
r = (end cash/start cash)(1/n) – 1
= (102/100)(1/2) – 1
= 0.0099505
= 0.99505% per period
This is also the periodic growth rate per period, for the total maturity of two periods.
The rate of return per period is roughly half of (102/100) – 1 = 2%. But not exactly, because of
interest on interest.

6 VALUE OF MONEY IN DIFFERENT CURRENCIES

Treasurers’ responsibilities include analysing and dealing with foreign currencies. To make
comparisons between money amounts in different currencies, they need to be translated into
a common currency. This will usually be the domestic currency of the organisation.

6.1 FOREIGN EXCHANGE (FX) RATES

The relationship between the values of two currencies is given by the foreign exchange (FX)
rate.
For example, GBP 1 = 1.10 EUR (GBP/EUR = 1.10)
The EUR equivalent value of GBP 100m is:
100 × 1.10
= EUR 110m
From the perspective of a EUR-based company the exchange rate quotation GBP 1 = 1.10 EUR
used above is sometimes known as a ‘direct’ quotation, meaning that the foreign currency
amount (GBP) is multiplied by the quoted rate of 1.10 to obtain the domestic currency (EUR)
equivalent.

Certificate in Treasury | 48
6.2 DIVIDING BY FX RATES
Depending which way round an FX rate is quoted, we may need to divide by it (rather than
multiplying).
For example, for an EUR-based company the quotation:
EUR 1 = USD 1.15 (EUR/USD = 1.15)
is sometimes known as an ‘indirect’ quotation.
This means that foreign currency (USD) amounts are divided by the quoted rate of 1.15, to
calculate the domestic currency (EUR) equivalent.
Continuing the example, given EUR 1 = USD 1.15, the EUR equivalent value of USD 100m is
calculated by dividing by the indirect FX quote:
100/1.15 = EUR 86.96m.

7 THE TIME VALUE OF MONEY

Money has a time value. A fixed amount of cash received or receivable today is worth more
than exactly the same cash sum receivable in the future. This is because amounts held today
can be invested.
By the future date, they will be worth the original amount invested, plus investment gains. A
simple example is the interest earned on a cash deposit.
Therefore the timing of a cash flow, as well as the amount of cash, has an impact on its value.
To compare cash flows payable or receivable on different dates, we need to make appropriate
adjustments.
To make adjustments appropriately we need to consider future values, present values and
discounting using discount factors.

7.1 FUTURE VALUE

Future values are cash flows expected on future dates.

7.2 PRESENT VALUE

Present values are either:

 cash flows payable or receivable today, or

 the equivalent value today of an expected future cash flow, appropriately discounted

7.3 DISCOUNT FACTORS

A discount factor is a number less than 1, which we multiply a future value by, to calculate its
present value.
PV = FV × DF
Where:
PV = present value
FV = future value
DF = discount factor

Certificate in Treasury | 49
 EXAMPLE 4: Present value calculation
Our company is due to receive USD 100m, one period in the future. The appropriate discount
factor is 0.9804. Calculate the present value of this expected future receipt.

Solution
PV = FV × DF
= 100 × 0.9804
= USD 98.04m

DISCOUNT FACTOR CALCULATION

The appropriate amount of discounting to apply is a combination of the rate of return per
period (r) and the number of periods’ delay (n).
The discount factor is calculated as:
DFn,r = (1 + r) –n
Where
r = rate of return per period
n = number of periods

EXAMPLE 5: Discount factor calculation

The periodic rate of return is 2% (0.02) and the number of periods’ delay until an expected
future cash flow is 1.
Calculate the appropriate discount factor.

Solution
DF1,0.02 = (1 + 0.02) –1
= 0.9804

This figure of 0.9804 would be applied to an expected future cash flow one period in the
future, to calculate its present value.

8 ROUNDING AND SPURIOUS ACCURACY

8.1 ROUND APPROPRIATELY FOR THE CONTEXT

Rounded result
Investment C gives GBP 100m after one period for an initial investment of GBP 98m.
To the nearest 0.01%, the periodic rate of return (r) is:
r = (end cash/start cash) – 1
= (100/98) – 1
= 2.04%

Certificate in Treasury | 50
To greater accuracy
Calculating (100/98) – 1 on your calculator, you will normally see many more decimal places,
for example:
0.02040816327
(= 2.040816327%)
For most purposes, that degree of accuracy would be too much. We will normally round
numbers off for presentation. The degree of rounding which is suitable will depend on the
purpose for which the figures are prepared.
Rounding the figure of 2.040816327% to fewer decimal places, the following rounded figures
are all correct, to the reducing levels of accuracy reported:
2.040816327%
2.04081633%
2.0408163%
2.040816%
2.04082%
2.0408%
2.041%
2.04%
2.0%
2%

8.2 ROUND, DON’T TRUNCATE

Notice for example that 2.0408%, rounded to the nearest 0.001%, is 2.041%.
It is not correct to simply cut off the final digit.
For example, to report 2.0408% as ‘2.040%’ is wrongly ‘truncating’ the figure, rather than
correctly rounding it to 2.041%.

8.3 ROUNDING ERRORS

When a rounded number is reused for a later calculation, it can result in a ‘rounding error’.

EXAMPLE 6: Rounding errors and how to avoid them

The periodic rate of return on Investment C is 2.0408% (to the nearest 0.0001%), based on an
initial investment of GBP 98m and a total repayment after one period of GBP 100m.
a) Express the periodic yield to the nearest 0.1%.
b) Use your rounded result in part a) to recalculate the total repayment after one period,
to the nearest GBP 0.001m.
c) Use the more accurate periodic return figure of 2.0408% to recalculate the total
repayment after one period, to the nearest GBP 0.001m.
d) Comment briefly on your results.

Certificate in Treasury | 51
Solutions
a) 2.0408% rounds to 2.0%, to the nearest 0.1% (= 0.020).
b) Total repayment recalculated using r = 0.020:
GBP 98m × (1 + 0.020)
= GBP 99.960m
c) Total repayment recalculated more accurately using r = 2.0408% = 0.020408:
GBP 98m × (1 + 0.020408)
= GBP 100.000m (to the nearest GBP 0.001m)
d) Comments:
When we used the rounded figure of 2.0% in part b) it resulted in a rounding error of:
100 – 99.96 = GBP 0.04m (= GBP 40k).

Notice though the difference in the percentage rate applied was only 2.0408% – 2.0% =
0.0408%, it resulted in a substantial rounding error of GBP 40k. When even small percentage
differences are applied to very large sums, like GBP 98m, the money differences become
substantial.
Rounding errors are reduced by keeping greater accuracy in the intermediate calculations.
Unfortunately there are no very simple rules which can be applied to know how much
accuracy is appropriate in different contexts. It all depends on the purpose to which the results
are going to be put.

8.4 SPURIOUS ACCURACY

Spurious accuracy means reporting results with too much precision.
If the calculation is based on estimates, this may be misleading for the user of the information,
implying a greater degree of certainty about the results than is justified.
For this reason, it is often best to round off a final figure for reporting, depending on the
intended use of the reported figure.

9 ABBREVIATIONS (K, M AND BN)

Results are often easier to understand without too many zeros.

9.1 THOUSANDS
The abbreviation ‘k’ or ‘K’ means thousands.
For example, EUR 100k means EUR 100,000.
Thousands can also be written as 103.

Certificate in Treasury | 52
9.2 MILLIONS AND BILLIONS
Similarly, ‘m’ means millions:
USD 100m means USD 100,000,000.
Millions can also be written as 106.
In finance ‘bn’ means billions (109).
GBP 100bn means GBP 100,000,000,000.
Historically in the UK and in some other countries, ‘billion’ used sometimes to refer
mathematically to 1,000,000,000,000 (or 1012). This historical usage never became well-
-established in finance, and is now – for practical purposes – defunct.

10 SUMMARY
In this reading you have reviewed and worked with the essential numerical concepts of:
 data analysis and interpretation
 monitoring cash flow and forecasting the need for other funds
 forecasting and calculating return on investments
 the value of money in different currencies
 the time value of money and discounting
 appropriate rounding and avoiding rounding errors
 spurious accuracy
 abbreviations (k, m and bn).

ENHANCE YOUR UNDERSTANDING

Now that you have completed this reading, review the webinar to enhance your
understanding. The webinar is accessible from your course page.

Certificate in Treasury | 53
 READING
2.2
Interest rate market conventions
1 INTRODUCTION
The ability to undertake interest rate calculations is a fundamental skill for treasurers and for
everyone working in finance. In this reading you will look at market conventions for quoting
interest, the forms that interest can take and how it is calculated for a variety of investment
periods.
An interest rate is the cost of borrowing, or the gain from lending, usually expressed as an
annual percentage rate. Interest is normally calculated by dividing the amount of interest by
the amount of principal. Interest rates change with factors such as supply and demand for
money, inflation and central bank policies.

LO6 Calculate the common types of interest rates and use them to
compare short-term borrowing costs and returns on short-term
investments.

2 DEFINITIONS
2.1 INTEREST
Interest is the income earned from lending or investing a sum of money (the capital, or
principal).
The interest rate is defined as the amount of interest earned for the period concerned per
unit of currency invested at the beginning of the period.
It is conventionally quoted as a percentage rate per year (per annum).

2.2 SHORT-TERM DISCOUNT RATES

The short-term discount rate is the return for a period, per unit of currency payable at the end
of the period.
Discount rates are also conventionally quoted as a percentage rate per annum.
In this context ‘short-term’ generally means up to and including a year’s maturity.

3 BASIS POINTS
When quoting interest rates, 0.01% is known as a ‘basis point’, i.e. one hundredth of a percent.
So if the interest rate rises from 7.50% (0.0750) to 7.54% (0.0754), it has increased by four
basis points.
1% is 100 basis points. ‘Basis points’ is sometimes abbreviated to ‘bp’.
Certificate in Treasury | 54
 EXAMPLE 1: Interest rate conventions
If interest of GBP 15m is payable at the end of a year in respect of an investment or loan of
GBP 200m, then the annual rate of interest is 15/200 = 0.0750 expressed as a decimal, or
100% × 0.0750 = 7.50% expressed as a percentage.
The interest rate has been calculated from a reference rate of 2.50% plus a credit risk margin.
Calculate the credit risk margin, in basis points.

Solution
The margin is 7.50% – 2.50% = 5.00% (equivalent to 500 basis points)

4 DAY COUNT CONVENTIONS

Day count conventions define how the market calculates the fraction of a year in order to
calculate an interest or discount amount.
Wholesale market rates are conventionally quoted per annum, so we need to be able to
calculate the actual amount owing for the period being quoted, say a week or a month or an
odd number of days.
To calculate return exactly, weeks or months are usually converted to a number of days, so in
practice it is necessary to know the exact date on which, for example, a six-month deposit
starts, so as to calculate the exact number of days covered.
The day count convention is expressed as:
days between two dates/days in a conventional year
In each financial market, both ‘days between two dates’ and ‘days in a conventional year’ are
determined by that market’s conventions.
Interest is earned, in most cases, on the number of nights money is deposited, rather than the
number of days. However, days is still often used as the terminology for the period.

4.1 DAYS BETWEEN TWO DATES

Most markets calculate the days between two dates on an ‘actual’ basis (abbreviated to ‘act’),
i.e. the actual number of days between the two dates. But remember the best way to establish
this is to consider the number of nights the money 'sleeps' at the bank. For example, if you
deposit your money at 9am Monday and withdraw it at 9pm on Tuesday, you may consider
this to be two days. However, it has only slept at the bank for one night. As such you will be
credited with only one day's interest.

Calculating actual days

It is necessary to know the number of days in each month:
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
31 28/29 31 30 31 30 31 31 30 31 30 31
Leap years are generally years divisible by 4 (for the period 1901 to 2099).
So for example 2016, 2020 and 2024 are all leap years. Leap years have 29 days in February,
and 366 days in the whole year.
Certificate in Treasury | 55
 EXAMPLE 2: Finding actual days
Finding the actual number of nights (i.e. the number of nights the money sleeps with the bank)
between each of the following start and end dates:
Start End Actual days
01/01/19 02/01/19 1
01/01/19 31/01/19 31 – 1 = 30
01/01/19 01/02/19 31
01/01/19 01/01/20 365
01/01/19 31/12/19 364
01/01/16 01/03/16 For leap year 2016,
30 + 29 + 1 = 60, or 31 + 29 = 60
01/01/19 18/06/19 31 + 28 + 31 + 30 + 31 + 17 = 168

4.2 DAYS IN A CONVENTIONAL YEAR

Short-term money markets trade in maturities up to and including one year.
The two most common conventions in the short-term money markets are:
actual days/a 360-day year
and
actual days/a 365-day year.
These are commonly abbreviated to act/360 and act/365 Fixed respectively.
Many short-term markets, including EUR and USD, use the act/360 day convention, whilst
some other short-term markets such as GBP money markets, use the act/365 Fixed convention.
The act/360-day convention is sometimes also known as the Money Market Yield, or MMY
convention. The act/365-day convention is sometimes known as the Bond Equivalent Yield, or
BEY convention.

Converting the year basis (360 v 365-day year)

Treasurers need to be able to compare rates on instruments that are quoted on a different
year basis.

To convert from a 360-day year to a 365-day year basis

Multiply by 365/360.
For example, if the 360-day rate is 4.0000%, the 365-day rate is:
4.0000% × 365/360 = 4.0556% (on a 365-day year basis)
The rate quoted on a 365-day basis is a higher number.

Certificate in Treasury | 56
To convert from a 365-day year basis
Multiply by 360/365.
For example, if the 365-day rate is 4.0556%, the 360-day rate is:
4.0556% × 360/365
= 4.0000% (on a 360-day year basis)
The same rate quoted on a 360-day basis is a lower number.

5 SIMPLE INTEREST RATES

There are various ways in which an interest rate, whether reflecting a return on an investment
or a cost of borrowing, can be quoted on different instruments and in different markets.
The fact that different instruments and markets quote returns in different ways is potentially
a problem, because it makes direct comparison between the rates on these instruments
invalid, unless appropriate adjustments are made. For valid comparisons to be made, the
returns and costs must be converted to a common basis across all instruments being
considered.
Four things needed to evaluate an interest rate are:
 the rate itself, usually quoted as a rate per annum
 how often interest is calculated and added to the principal, e.g. daily, monthly, semi-
annually, annually
 the day count convention
 whether the rate is quoted on a simple or compound basis.

Short-term rates
Markets conventionally quote interest rates for short-term investment and borrowing on a
simple basis per annum.
Simple interest is where the total interest for the given period is calculated only on the original
principal. In this case, no interest is earned on the interest accumulated in previous periods.
Where the market quotes an interest rate with an associated short-term period, this generally
indicates the rate quoted is on a simple basis per annum. For example, a 6% 60-day USD
deposit.
The value now of the principal to be invested is its present value. To calculate the future value,
i.e. the final or accumulated value, of principal plus interest, we use the formula:
FV = PV × ( 1 + (R × days/year ))
Where:
PV = present value (principal invested)
FV = future value (final or accumulated value of principal plus interest)
R = annual simple interest rate
days = number of days maturity
year = number of days in the conventional year (360 or 365)
Certificate in Treasury | 57
 EXAMPLE 3: Simple interest
A short-term deposit of USD 100k is made for 60 days at an annual simple interest rate of 2%
(act/360 basis).
Calculate the future value 60 days hence, of principal plus simple interest.

Solution
FV = PV × (1 + (R × days/year)) = USD 100,000 × (1 + (0.02 × 60/360))
= USD 100,333.33
The number of days in the conventional year in this example is 360, as the currency is US
dollars.

6 PERIODIC INTEREST RATES

Often interest is calculated and applied more often than once per year.
The interval of time between successive interest calculations is called a period. The interest
that is paid once per period is called periodic interest. The periodic rate is always a simple
interest rate.
The periodic interest rate is given by the formula:
r = R × days/year
Where:
r = periodic interest rate
R = annual simple interest rate
days = the number of actual days in the period
year = the number of days in a conventional year (360 or 365)

EXAMPLE 4: Periodic interest rate

USD 1m is invested in a 182-day US dollar certificate of deposit, quoted at an annual interest
rate (R) of 2% (act/360 basis).
Calculate the periodic interest rate and the interest amount for the 182 days.

Solution
r = R × days/year= 0.0.2 × 182/360
= 0.010111 (1.0111%)
The interest amount is: USD 1m × 0.010111 = USD 10,111.11
The future value is: FV = PV × (1 + r)
USD 1m × 1.010111
= USD 1,010,111.11

Certificate in Treasury | 58
Deriving simple annual rates
The simple annualised interest rate (R) can be derived from the periodic rate (r):
R = r × year/days

Whole months
When dealing with instruments that quote interest in whole months, for example semi-
annually, quarterly or monthly, a commonly-used short calculation is:
r = R/n
Where:
n = the number of periods in a year

EXAMPLE 5: Periodic interest rates

A GBP money market instrument is quoted at 2%, paying interest quarterly.
Calculate the periodic interest rate per quarter.

Solution
r = R/n
= 2%/4
= 0.5%

7 COMPOUND INTEREST RATES

Compounding means interest is payable on the interest, in addition to interest on the original
principal. Consequently, compound interest, for multiple compounding periods, is greater
than simple interest.

Compound interest for multiple periods:

FV = PV × (1 + r)n
Where:
n = number of compounding periods
r = periodic interest rate

EXAMPLE 6: Compound interest – annually

A deposit of GBP 100k is made for two years at an annual interest rate of 2%. Interest is paid
annually and reinvested. Calculate the future value two years hence of principal plus
compound interest.

Solution
FV = PV × (1 + r)n = GBP 100,000 × 1.022 = GBP 104,040
GBP 4,000 is interest on the principal, and GBP 40 is ‘interest on interest’

Certificate in Treasury | 59
 EXAMPLE 7: Compound interest – monthly
A deposit of GBP 100k is made for two years at an annual interest rate of 2%, with interest
compounded monthly.
Calculate the future value two years hence of principal plus compound interest.

Solution
Periodic rate per month (r) = 0.02/12
= 0.001667
Number of periods in 2 years (n)
= 12 × 2
= 24
FV = PV × (1 +r)n
= 100,000 × 1.00166724
= GBP 104,077.61

The total value at maturity is greater, because there is more interest on interest, at the same
nominal annual rate of 2%.

8 EFFECTIVE ANNUAL RATE (EAR)

In order to compare instruments on a common basis, we use the effective annual rate of
return (EAR). EAR is the annual rate of return after adjusting for the effects of compounding.
EAR assumes that interest is compounded at the end of each interest period. The EAR is
expressed as a periodic interest rate with interest paid once a year.
The EAR can be used to compare the returns of different nominal rates with different
compounding periods and conventional years (360 or 365 days).
The EAR is sometimes also known as the annual effective rate or the annual percentage rate.

Effective annual rate calculation:

EAR = (1 + r)n – 1
Where:
r = periodic interest rate
n = number of times a period fits into a calendar year

Certificate in Treasury | 60
 EXAMPLE 8: Calculating EAR
A loan has an amount outstanding with periodic interest of 0.3% charged weekly.
Calculate the effective annual rate.

Solution
EAR = (1 + r)n – 1
r = 0.003
n = 365/7
The EAR is:
1.003 (365/7) – 1
= 16.91%

Whole months
Again, when dealing with instruments that quote interest in whole months, for example semi-
annually, quarterly or monthly, we will often use whole numbers rather than exact
proportions of 365-day years.

EXAMPLE 9: Calculating EAR

A deposit offers 0.1667% periodic interest with monthly interest payments.
Calculate the effective annual rate.

Solution
The EAR is:
EAR = (1 + r)n – 1
1.00166712 – 1
= 2.0184%
If the same deposit offered 0.1667% periodic interest with quarterly interest payments, the
EAR would be:
1.0016674 – 1
= 0.6683%

Certificate in Treasury | 61
9 NOMINAL ANNUAL RATES
9.1 NAMED RATES
A nominal rate is one which is quoted, or named, in a given market. In the wholesale markets,
rates are almost always quoted per annum.
A rate quoted per annum is known as a nominal annual rate. Nominal rates are sometimes
also known as ‘headline’ rates.
For example, a 60-day USD nominal rate of 6% means that the periodic interest for 60 days is:
0.06 × 60/360
= 0.01 (= 1.00%)
The effective annual rate (EAR) therefore is (noting EAR’s are always on a 365 basis
irrespective if currency):
1.01(365/60) – 1
= 6.2401%
Taking another example, a one-year GBP nominal rate of 3% means that the periodic interest
is 3% for the year, and the annual effective rate is also 3%.

9.2 RATES INCLUDING INFLATION

The term ‘nominal’ is also used to indicate that a rate or amount includes inflation.

10 REAL RATES
Real rates are ones which have been adjusted for inflation.
They include real interest rates and real growth rates.

10.1 REAL INTEREST RATES

Rates of interest or return quoted in the markets conventionally include inflation. These
conventional rates are sometimes also known as ‘money’ rates or ‘nominal’ rates.
Some practitioners think and talk about real rates, which are the money rates, adjusted to
exclude the effects of inflation.
The link between inflation rates, real rates and nominal rates (or money rates) is:

1  nominal rate
1  real rate 
1  inflation rate
When inflation is positive, the real interest rate is lower than the nominal interest rate.

EXAMPLE 10: Real interest rate, nominal rate and inflation rate
The money interest rate is 2% annual effective rate, and the inflation rate is 1.5% per annum.
Calculate the real interest rate.

Certificate in Treasury | 62
Solution
The real interest rate is calculated using:

1+ 0.020
1+ real rate =
1+ 0.015
= 1.004926
real rate = 1.004926– 1
= 0.4926%
Looking at it another way, if the real interest rate is 0.4926% and inflation is 1.50%, the money
(nominal) rate is given by:

1+ nominal rate
1+ 0.004926 =
1+ 0.015
Therefore, the nominal (money) rate
= (1.004926 × 1.015) – 1 = 2%.

10.2 REAL GROWTH RATES

Levels of activity may appear to be growing when expressed in money (or nominal) terms, but
may actually be declining when expressed in inflation-adjusted terms.
The real rate of growth or decline is the inflation-adjusted rate.
The same relationship applies to growth rates as to interest rates:

1  nominal rate
1  real rate 
1  inflation rate
When inflation is positive, the real growth rate is smaller than the nominal (or money) growth
rate.
Indeed the real rate of growth may be negative, i.e. a decline in real (inflation-adjusted) levels
of activity.

EXAMPLE 11: Modest nominal growth, decline in real terms

Z SA’s revenues are growing at 1% per annum in money terms.
The rate of inflation is 3% per annum.
Calculate the real rate of Z’s revenue growth or decline.

Solution
(1 + real rate) = (1 + nominal rate)/(1 + inflation rate)
real rate = ((1 + nominal rate)/(1 + inflation rate)) – 1
= (1.01/1.03) – 1
= – 0.0194
= – 1.94% (decline)

Certificate in Treasury | 63
Sales volumes are declining at nearly 2% per year.
It is only because of the inflation rate of 3% per year that revenues are growing in money
terms.

11 SUMMARY
In this reading, you have seen how to calculate the common types of interest rates, in order
to use them for comparing short-term borrowing costs, and returns on short-term
investments.
You have looked at:
 the definition of interest rate and its importance in finance
 the annual interest convention
 the basis points of interest rates
 simple, periodic and compound interest rates
 effective annual rate
 the role of day count conventions on interest amount calculation
 the definition of settlement convention
 the various ways in which an interest rate can be quoted on different instruments and
in different markets
 real rates, inflation and nominal rates

ENHANCE YOUR UNDERSTANDING

Now that you have completed this reading, review the webinar to enhance your
understanding. The webinar is accessible from your course page.

Certificate in Treasury | 64
 READING
2.3
Yield and discount
1 INTRODUCTION
The ability to work with interest and discount calculations is essential for the treasurer. You
have already looked at market conventions for quoting rates of return and how they are
computed for different investment and borrowing periods. In this reading you will go on to
related concepts including discount, redemption value and yield, and compare returns and
costs between different instruments.

LO7 Calculate short-term yields, discount rates, redemption values and

market prices to enable appropriate comparisons between different
short-term instruments.

2 YIELD AND REDEMPTION VALUE

Many tradeable instruments are quoted or evaluated in the market in terms of a yield. The
yield is an implied interest rate that takes into consideration interest payments, market value,
redemption value, and the time remaining until maturity. Because yield takes market values
and redemption values into account, yield is often different from any nominal rate of interest
which may have been attached to the instrument on its issue.
Short-term yields are quoted in the market as nominal rates (annualised on a simple basis)
and denote a rate of return as a percentage of the opening or starting amount.
The redemption value is the value of the instrument at maturity, i.e. future value, and the
market value is the value at which the investment can be purchased in the market, i.e. current
value.

3 CALCULATING REDEMPTION VALUE AND YIELD

3.1 REDEMPTION VALUE CALCULATION
To calculate the redemption value of an instrument, we use the formula:
redemption value = market price × (1 + (nominal annual yield × days/year))
or
FV = PV × (1 + (R × days/year))
Where =
FV = future value or redemption value
PV = present value or market price
Certificate in Treasury | 65
R = nominal annual yield
days = days remaining maturity
year = 360 or 365 days, in the conventional year

EXAMPLE 1: Calculation of redemption value

We are considering investing EUR 50,000,000 in Certificates of Deposit (CDs) with a remaining
maturity of 60 days, quoted in the market at a yield of 5%.
The redemption value is:
50,000,000 × (1 + (0.05 × 60/360))
= EUR 50,416,667
The number of days in the conventional year is 360, as the currency is EUR.

3.2 YIELD CALCULATION

We may need to calculate the nominal annual yield (R), i.e. the implied rate of return from
the investment, in order to compare it with other quoted market rates.
Where we know the market price and the redemption value only, the yield is calculated as
follows:
periodic yield (r) = (end cash/start cash) – 1
r = (redemption value/market price) – 1
nominal annual yield (R) = r × year/days

EXAMPLE 2: Calculating yield

A money market deposit is made for GBP 1 million for 272 days and it will return GBP
1,030,000.
The instrument’s yield is:
r = (redemption value/market price) – 1
= (1,030,000/1,000,000) – 1
= 0.03 periodic yield
= 3% per 272 days
R = r × year/days
= 3% × 365/272
= 4.0257% nominal annual GBP yield
The number of days in the conventional year in this example is 365, as the currency is GBP.

Short cut calculation of R

R = ((redemption value/market price) – 1) × year/days
= ((1,030,000/1,000,000) – 1) × 365/272 = 4.0257%

Certificate in Treasury | 66
4 DISCOUNT INSTRUMENTS
Some instruments, such as commercial paper, provide a return to investors not by paying
interest, but by being sold at a discount to their face value, with the face value being payable
at maturity.
As discount instruments are issued at a discount, the issuer receives less than the face value.

4.1 DISCOUNT AMOUNT

The difference between the face value and the amount received on issue, called the discount
amount, is the investor’s gain, paid by the issuer.
The discount amount is calculated as follows:
discount amount = redemption value × D × days/year
Where:
D = nominal annual discount rate
days = days remaining maturity
year = 360 or 365 days

EXAMPLE 3: Calculation of discount amount and issue proceeds

A discount instrument with a face value of EUR 250,000 is issued with a maturity of 30 days at
a discount rate of 5%.
The discount amount deducted at the time of issue is:
250,000 × 0.05 × 30/360
= EUR 1,041.67
So, the issue proceeds of the discount instrument are:
250,000 – 1,041.67
= EUR 248,958.33

4.2 SHORT-TERM NOMINAL ANNUAL DISCOUNT RATE CALCULATION

The short-term discount rate quoted in the market is the nominal annual discount rate
(annualised on a simple basis). The nominal annual discount rate is calculated in three steps
as:
a) discount amount = redemption value – market price
b) periodic discount rate (d) = discount amount/redemption value
c) nominal annual discount rate (D) = d × year/days

EXAMPLE 4: Calculation of discount rate

A USD instrument with a market value of USD 300,000 is issued with a maturity of 60 days,
when it will return USD 308,000.
The discount amount and discount rate are:
discount amount = redemption value – market value

Certificate in Treasury | 67
= 308,000 – 300,000
= USD 8,000
d = discount amount/redemption value
= 8,000/308,000
= 2.5974% per 60 days
D = d × year/days
= 2.5974% × 360/60
= 15.5844% nominal annual USD discount rate
Days in the short-term USD conventional year are 360.

Short cut calculation of D

((308,000 – 300,000)/308,000) × 360/60
= 15.5844%

5 CONVERTING BETWEEN DISCOUNT AND YIELD

Treasurers often need to convert between discount rates and yields in order to compare the
returns or costs between instruments of different maturities or quoted on different bases.

Conversion between periodic discount rate and periodic yield

Periodic yields are larger numbers than the equivalent periodic discount rates.
This is because the yield is based on a proportion of the market value of the instrument, which
is a smaller amount.
The equivalent discount rate is based on the redemption value, which is a larger number.
Say an instrument has a market price of USD 1.00m, and a redemption value of USD 1.03m at
the end of one period of 270 days.
The periodic yield (r) is:
r = (redemption value/market price) – 1
= (1.03/1.00) – 1
= 0.03 per 270 days
= 3%
The periodic discount rate (d) is:
d = discount amount/redemption value
= (redemption value – market price)/redemption value
= (1.03 – 1.00)/1.03
= 0.03/1.03

Certificate in Treasury | 68
 = 0.029126 per 270 days
= 2.9126%

5.1 CONVERTING PERIODIC YIELD (R) TO PERIODIC DISCOUNT RATE (D)

d = r/(1 + r)
Where:
d = periodic discount rate
r = periodic yield
For example:
r = 0.03 per 270 days
d = 0.03/1.03
= 0.029126 per 270 days
=2.9126%

5.2 PERIODIC DISCOUNT RATE TO PERIODIC YIELD

r = d/(1 – d)
For example:
d = 0.029126 per 270 days
r = 0.029126/(1 – 0.029126)
= 0.030000 per 270 days
= 3.0000% to the nearest 0.0001%

5.3 NOMINAL ANNUAL YIELD (R) TO NOMINAL ANNUAL DISCOUNT RATE (D)

Steps
a) Convert to periodic rate (r)
b) Convert between periodic rates (r to d)
c) Convert to nominal annual rate (d to D)
Let’s take the example of a USD (360-day year) instrument, with a nominal annual yield (R) of
4% (0.04). The remaining maturity is 270 days.
a) Convert to periodic rate (r):
r = R × days/year
= 0.04 × 270/360
= 0.03 per 270 days
b) Convert between periodic rates (r to d):
d = r/(1 + r)
= 0.03/1.03
= 0.029126 per 270 days
Certificate in Treasury | 69
c) Convert to nominal annual discount rate (d to D):
D = d × year/days
= 0.029126 × 360/270
= 3.8835% nominal annual USD discount rate (for 270 days’ maturity)

5.4 NOMINAL ANNUAL DISCOUNT RATES TO NOMINAL ANNUAL YIELDS

We can also use the same relationship in the other direction.

Steps
a) Convert annual discount rate to periodic (D to d)
b) Convert between periodic rates (d to r)
c) Convert to nominal annual rate (r to R)

EXAMPLE 5: Converting nominal annual discount rate to nominal annual yield

A 270-days USD instrument is quoted at a nominal annual discount rate of 3.8835%
(0.038835).
Calculate the nominal annual yield.

Solution
Following the steps in turn:
a) Convert to periodic discount rate (d):
d = D × days/year
= 0.038835 × 270/360
= 0.029126 per 270 days
b) Convert between periodic rates (d to r):
r = d/(1 – d)
= 0.029126/(1 – 0.029126)
= 0.030000 (to the nearest 0.000001)
c) Convert to nominal annual yield (R):
R = r × year/days
= 0.030000 × 360/270
= 0.04
= 4.00% nominal annual USD yield (for 270 days’ maturity)

Certificate in Treasury | 70
6 COMPARING INSTRUMENTS ON A LIKE-FOR-LIKE BASIS (EAR)
It is often necessary to convert between rates in order to compare returns or costs between
different instruments. The best basis of comparison is normally the effective annual rate
(EAR). Evaluation with the EAR brings together simple interest, compounding and different
periods, to make the EAR comparison.
EAR also deals well with both 365- and 360-day year bases.

6.1 CONVERTING NOMINAL ANNUAL YIELDS (R) TO EAR

Working step by step:
a) Convert nominal annual yields (R) to periodic yield (r)
b) Convert periodic yield to EAR

35-day USD yield instrument

Say a 35-day USD certificate of deposit is quoted at a nominal annual yield (R) of 4%.

a) Convert R to periodic rate (r)

r = R × days/year
= 0.04 × 35/360
= 0.00388889 per 35 days

b) Convert periodic yield to EAR

EAR = (1 + r)n – 1
Where:
n = number of times period fits into a calendar year = 365/35
EAR = 1.00388889(365/35) – 1
= 4.1307% EAR

Why EAR is a higher number

The effective annual rate of 4.13% is a higher number than the USD nominal annual 35-day
yield of 4% because of compounding.
The EAR being based on a calendar year of 365 days (v. 360-day conventional year for short-
term USD).

EXAMPLE 6: Converting short-term yields to EARs

Convert the following GBP yields to an EAR basis:
a) 8.00% annual (n = 1)
b) 7.90% semi-annual (n = 2)
c) 7.80% quarterly (n = 4)
a) Interest is payable after one year at 8% (0.08).
r = 0.08 per year

Certificate in Treasury | 71
n=1
EAR = (1 + r)n – 1
= 1.081 – 1
= 8.00%
b) Interest is payable after 6 months (half a year) at 7.9% nominal annual rate.
r = 0.079 × 6/12
= 0.0395 per six months
n = 12/6 = 2
EAR = 1.03952 – 1
= 8.06% (to the nearest 0.01%)
c) Interest is payable after three months at 7.8% nominal annual rate.
r = 0.078 × 3/12
= 0.0195 per three months
n = 12/3 = 4
EAR = 1.01954 – 1
= 8.03 % (to the nearest 0.01 %)

Figure 1: Summary of R, n, r and EAR

We have assumed a 365-day year and used whole months to estimate exact day counts.
The more frequently that a given nominal annual yield is compounded, the greater the
effective annual rate.

6.2 NOMINAL ANNUAL DISCOUNT RATES (D) TO EAR

Working step by step:
a) Convert nominal annual discount rate (D) to periodic discount rate (d)
b) Convert periodic discount rate (d) to periodic yield (r)
c) Convert periodic yield to EAR

35-day USD discount instrument

Say a 35-day USD discount instrument is quoted at a nominal annual discount rate (D) of 4%.
a) Convert nominal annual discount rate to periodic (d)
d = D × days/year

Certificate in Treasury | 72
= 0.04 × 35/360
= 0.00388889 per 35 days
b) Convert periodic discount rate to periodic yield (r)
r = d/(1 – d)
= 0.00390407 per 35 days
c) Convert periodic yield to EAR
EAR = (1 + r)n – 1
n = 365/35
EAR = 1.00390407(365/35) – 1
= 4.1471% EAR
The return on this discount instrument can now be compared with instruments of different
maturities or different conventional bases of quotation.
We can compare their EARs.
All other things being equal, the more favourable EAR would be the preferred choice.

EXAMPLE 7: EAR of a 91-day GBP discount instrument

A GBP instrument has 91 days remaining maturity and it is quoted at a discount rate of 5%.
Calculate the annual effective rate of return (EAR).

Solution
a) d = D × days/year
= 0.05 × 91/365
= 0.01246575 per 91 days
b) r = d/(1 – d)
= 0.01246575/(1 – 0.01246575)
= 0.0126231 per 91 days
c) Convert periodic yield to EAR
EAR = (1 + r)n – 1
n= 365/91
EAR = 1.012623(365/91) – 1
= 5.1601%

Certificate in Treasury | 73
Figure 2: EAR comparison

In relation to investments, the effective annual rate (EAR) is a measure of yield.

For borrowings, the EAR is a measure of cost.

6.3 OTHER RELEVANT FACTORS WHEN COMPARING INSTRUMENTS

The most important other factor in comparing instruments is their relative risk.
For investments, risk relates primarily to safety (or ‘security’), in other words the risk that the
principal invested may be lost.
For borrowings, risk is a broader concept, including the continued availability of the borrowed
funds.
When comparing instruments, risk and maturity should always be considered, as well as EAR.

7 SUMMARY
In this reading you have seen how to calculate short-term yields, discount rates, redemption
values and market prices, in order to enable us to make appropriate comparisons between
different short-term instruments. You have looked at:
 how to calculate redemption value, yield and discount amounts
 how to convert between discount and yield
 how to convert nominal interest rates to effective annual rates
 the use of effective annual rates to compare any short-term instrument with any
other

ENHANCE YOUR UNDERSTANDING

Now that you have completed this reading, review the webinar to enhance your
understanding. The webinar is accessible from your course page.

Certificate in Treasury | 74
 READING
2.4
The yield curve
1 INTRODUCTION
Yields (rates of return) available for investment in the market depend on a number of different
factors, including the maturity of the investment.

LO8 Examine the various yield curves, what they are used for and the
relationships between them, including calculations, to ensure the correct
rates are used for given tasks.

2 THE TERM STRUCTURE OF INTEREST RATES

A yield curve is a summary of market yields today for comparable instruments of increasing
maturities. The yield curve is also known as the term structure of interest rates.

3 WHY YIELDS DIFFER FOR DIFFERENT MATURITIES

A yield curve can adopt a number of different shapes.

Figure 1. Yield curve shapes

There are a number of theories about the reasons for the shapes of the curves.

3.1 MARKET EXPECTATIONS

According to market expectations theory a positive yield curve reflects an expectation that
market rates will rise. According to this theory, a negative yield curve would reflect an
expectation that market will fall.

Certificate in Treasury | 75
3.2 LIQUIDITY PREFERENCE
Liquidity preference theory suggests investors demand a risk premium or compensation, in
the form of higher rates, for tying up funds for longer periods. Therefore, longer-term rates
would be higher, to compensate investors for their loss of liquidity.

3.3 MARKET SEGMENTATION

The market interest rate at a point on the yield curve is the price of money that balances
supply and demand. Demand and supply differ with term to maturity, resulting in different
prices for different maturities.

4 KEY DEFINITIONS IN UNDERSTANDING YIELD CURVES

4.1 COUPON BOND
A bond that pays intermediate interest is known as a coupon bond, to differentiate it from a
zero-coupon bond, which pays no periodic coupons.

4.2 PAR BOND

A coupon bond whose yield is equal to its coupon rate trades in the market at a value of par
(= 100% of the face value). It is called a par bond, because it trades at par.

4.3 ZERO COUPON BOND

Bonds that pay no periodic coupons, but only a redemption amount at maturity, are known
as zero coupon bonds.

4.4 ZERO COUPON RATE

The rate of return on an investment made today, based on a single cash flow at the maturity
of the instrument, is known as the zero coupon rate.
The zero coupon rate is also sometimes known as the spot rate.

4.5 FORWARD RATE

The forward rate is the rate of return in the market today for a notional or actual deposit or
borrowing, a) starting in the future, and b) ending further in the future.

4.6 PAR RATE

Today’s yield on a coupon bond trading at par and redeemable at par is equal to the fixed
coupon rate payable on the bond. This yield is known as the par yield or the par rate.
It is also known as the swap rate, because of its use in pricing interest rate swaps.

5 TYPES OF YIELD CURVE

5.1 PAR YIELD CURVE
The par yield curve plots the coupon rates of coupon paying bonds of equivalent credit risk all
of which are trading at ‘par’, i.e. at their face value, but each of which has a different maturity.

Certificate in Treasury | 76
Par rates are used for determining:
 the coupon rate on a new bond redeemable at par, for it to be issued successfully at its
par value
 the fixed leg rate of a new interest rate swap (swap pricing)

5.2 ZERO COUPON YIELD CURVE

Zero coupon rates relate to single future cash flows, for example the maturity amounts of zero
coupon bonds.
The only accurate method of valuing future cash flows is to discount each separate future cash
flow using the appropriate zero coupon rate for the maturity and currency of the respective
cash flow.

5.3 FORWARD YIELD CURVE

Forward rates are used for determining:
 historically, ‘forward forward’ rates for physical deposits or borrowings
 the rates for related derivative instruments, known as ‘forward rate agreements’ (FRAs)
 forward interest rates also provide the best available current market information about
the market’s expectations of future out-turn interest rates. This is an aspect of market
expectations theory.

5.4 EACH YIELD CURVE ENCOMPASSES THE OTHER TWO CURVES

The yield curve for instruments of a given risk can be expressed as a zero coupon yield curve,
a forward yield curve or a par yield curve. If any one set of rates (zero coupon, forward or par)
is known, then each of the other two related yield curves can be calculated from it.

6 THE NO ARBITRAGE RELATIONSHIP BETWEEN YIELD CURVES

Figure 2: Relationship between forward, zero and par rates

Arbitrage means identifying discrepancies between quoted market prices and then
transacting simultaneously at those misaligned prices to earn risk free ‘arbitrage’ profits.
Thus, an investment at one of the three rates, say the zero coupon rate, must generate the
same future cash as the equivalent investment in, say, the forward rates, otherwise an
investor could generate a risk-free profit.

Certificate in Treasury | 77
6.1 FOR A SINGLE CASH FLOW, ALL RATES ARE THE SAME
All three curves start from the same point. All represent the same deal, so the rates must be
the same.

Figure 3: All curves are the same for the first period

6.2 WHEN PERIODIC RATES RISE FOR SUBSEQUENT SAME-LENGTH PERIODS

In this example, as we move to Time 2, the cash flows are not the same for each rate.

Figure 4: Curves differ for longer maturities

If an investor has GBP 100m to invest for 2 years, the investor can invest in:

 a zero coupon 2-year instrument, or

 two sequential forward rates: Time 0-Time1 followed by Time 1-Time 2, or
 a two-year par rate instrument

Taking just the first two possibilities, the zero coupon investment involves a Time 0 investment
and a Time 2 return of principal and interest.
The forward rate investment involves a Time 0 investment followed by a Time 1 return of
principal and interest, a reinvestment of that principal and interest and a final return of
principal and accumulated interest at Time 2.

EXAMPLE 1: Calculating zero coupon rate

If the forward rates are: Time 0-Time 1 5% EAR
Time 1-Time 2 6% EAR
Then an initial GBP 100m investment will grow to:
100 × (1+5%) = GBP 105.00m at Time 1, reinvested at 6% to grow to
105 × (1+6%) = GBP 111.30m at Time 2
For the no-arbitrage rule to be satisfied, the zero coupon two-year investment must lead to
the same result, so:
100 × (1 + rz2)2 = 111.30
Where:

Certificate in Treasury | 78
rz2 = annual effective coupon rate for 2 years’ maturity.
Rearranging the formula:
100 × (1 + rz2)2 = 111.30/100
(1 + rz2)2 = (111.30/100)(1/2)
1 + rz2 = (111.30/100)(1/2)
rz2 = (111.30/100)(1/2) – 1
= 5.4988% EAR

7 FORWARD AND ZERO COUPON YIELDS RELATIONSHIP

(1 + rlong) = (1 + rshort) × (1 + rshort v long)
Where:
rshort = e.g. 1-period zero coupon periodic rate, r0-1
rlong = e.g. 2-period zero coupon periodic rate, r0-2
rshort v long = e.g. periodic forward rate between Time 1 and 2 periods hence, r1-2
This formula illustrates that the terminal cash from alternative market investments is the
same. Both sides of the formula are the same terminal cash amount.

8 CONVERTING FORWARD AND ZERO COUPON RATES

8.1 ZERO COUPON RATES TO FORWARD RATES CONVERSION STEPS
a) Calculate periodic zero coupon rates (r0-n)
b) Calculate terminal cash flows from zero coupon investments
c) Forward periodic rates (r(n-1)-n) = (end cash/start cash) – 1
d) Convert forward periodic rates (r) to nominal annual rates (R)

EXAMPLE 2: Short-term forward rates calculation

Today’s quoted short-term (nominal annual) GBP zero coupon rates are:
Maturity Short-term GBP zero coupon yield
0-3 months 6%
0-6 months 6%
0-9 months 6%
a) Set out the cash flows for the related zero coupon instruments, assuming an initial
investment of GBP 1,000,000 in each case.
b) Calculate the periodic yields for the periods 3-6 months and 6-9 months, from the
cash flows at 3, 6 and 9 months respectively (as calculated in part a)).
c) Calculate the nominal annual yields for the periods 3-6 months and 6-9 months, from
the periodic yields for the 3-month forward periods (as calculated in part b)).

Certificate in Treasury | 79
Solution
Amounts returned to investors of GBP 1,000,000, all at Time 0 months, for different short-
term periods, all at nominal annual rates of 6% = 0.06.
a)
For periods of i) 0-3 months, ii) 0-6 months and iii) 0-9 months, all in GBP:
i) 1,000,000 × (1 + (0.06 × 3/12)) = 1,015,000
ii) 1,000,000 × (1 + (0.06 × 6/12)) = 1,030,000
iii) 1,000,000 × (1 + (0.06 × 9/12)) = 1,045,000
b)
Periodic yield (r):
= (end cash/start cash) – 1
i) r(3-6) = (1,030,000/1,015,000) – 1
= 0.014778
= 1.4778% for the 3-month period 3-6 months
ii) r(6-9) = (1,045,000/1,030,000) – 1
= 0.014563
= 1.4563% for the 3-month period 6-9 months
c)
The periods are both 3 months long, so in each case the conversion from the 3-month periodic
rate (r) to the simple interest nominal annual rate (R) is × 12/3 months.
i) 1.4778% × 12/3 = 5.9112% nominal annual rate for 3-6 months’ maturity.
ii) 1.4563% × 12/3 = 5.8252% nominal annual rate for 6-9 months’ maturity.

8.2 FORWARD RATES TO ZERO COUPON RATES CONVERSION STEPS

a) Calculate periodic forward rates (r(n-1)-n)
b) Calculate cumulative terminal cash flows from chain of forward rate investments
c) Zero coupon periodic rates (r(0-n) ) = (end cash/start cash) – 1
d) Convert periodic zero coupon rates (r) to nominal annual rates (R)

EXAMPLE 3: Short-term zero coupon rates calculated

Today’s short-term GBP forward yield curve is quoted as:
Maturity Quoted forward yield
0-3 months 6%
3-6 months 6%
6-9 months 6%

Certificate in Treasury | 80
 a) Set out the cash flows for the related forward instruments, assuming an initial
investment of GBP 1,000,000, with reinvestment of the maturing proceeds in the later
periods.
b) Calculate the periodic yields for the periods 0-6 months and 0-9 months, from the
cash flows at 6 and 9 months respectively (as calculated in a).
c) Calculate the nominal annual yields for the periods 0-6 months and 0-9 months, from
the periodic yields for the 6-month and 9-month zero coupon periods (as calculated
in b).

Solution
a)
Amounts returnable to an investor who initially invested GBP 1,000,000 at Time 0 months,
with successive reinvestment for further different short-term periods of 3 months’ maturity
each, all at nominal annual rates of 6%.
Cumulative amounts at the end of i) 3 months, ii) 6 months and iii) 9 months, all in GBP:
i) 1,000,000 × (1 + (0.06 × 3/12)) = 1,015,000 at Time 3 months
(Note the nominal annual ‘forward’ rate r(0-3) of 6% gives exactly the same result of 1,015,000
as the nominal annual zero coupon rate r(0-3) of 6%. This is because they represent identical
deals and cash flows. Both deals are to pay away cash at Time 0 months, and receive more
cash back at Time 3 months in the future.)
ii) Reinvesting the maturing proceeds at Time 3 months, for a further 3 months:
1,015,000 × (1 + (0.06 × 3/12)) = 1,030,225 (at Time 6 months)
iii) 1,030,225 × (1 + (0.06 × 3/12)) = 1,045,678 (at T = 9 months)
b)
Periodic yield (r):
= (End cash/start cash) – 1
i)
r(0-6) = (1,030,225/1,000,000) – 1 = 0.030225
= 3.0225% for the 6-month period 0-6 months
ii)
r(0-9) = (1,045,678/1,000,000) – 1
= 4.5678% for the 9-month period 0-9 months
c)
i) The 0-6 month period is 6 months’ long, so the conversion from the periodic rate (r) to the
nominal annual rate (R) is × 12/6 months:
3.0225% × 12/6 = 6.0450% nominal annual rate for 0-6 months’ maturity.
ii) However, the 0-9 month period is 9 months’ long, so in this case the conversion from the
periodic rate (r) to the nominal annual rate (R) is × 12/9 months:
4.5678% × 12/9 = 6.0904% for 0-9 months’ maturity.

Certificate in Treasury | 81
9 ZERO COUPON AND PAR RATES RELATIONSHIP
The derivation of par rates from zero coupon rates relies on the par bond present value
relationship: what must the fixed periodic coupon (c) on the bond be such that, given the
current zero rates, the value of such a bond is par (100% of its nominal value).
Stating this as an equation: 100 = c(1+r1)–1 + c(1+r2)–2 + …..+c(1+rn)–n + 100(1+rn)–n
Which can be simplified to: rpar = (1 – DFn)/CumDFn
Where:
rpar = par rate for n periods’ maturity
r1 etc. = the respective periodic zero coupon rates for each maturity
DFn = discount factor at time n
CumDFn = cumulative discount factor = sum of all periodic discount factors to time n
The discount factor at time n and the cumulative discount factor are calculated from the zero
coupon rates.

Zero coupon rates to par rates conversion steps

a) Calculate periodic zero coupon rates (r0-n) noting that Zero coupon periodic rates (r(0-n)) =
(end cash/start cash) – 1
b) Calculate discount factors from periodic zero coupon rates
c) Convert periodic zero coupon rates (r) to nominal annual rates (R) as the results from steps
a and b are only periodic rates, with market convention being that they are quoted annually.

EXAMPLE 4: Par rate calculation

Given the annual effective zero coupon rates set out in the table, calculate the related par
rates for maturities of
a) one year
b) two years
c) three years
Period ZCR
1 4%
2 5%
3 6%

Certificate in Treasury | 82
Solution
a) The one-year par rate is the same as the one-year zero coupon rate, because both rates
represent the identical market deal.
It is 4% annual effective rate.
b) The two-year par rate (n = 2 years) is calculated using the formula:
r(par,n) = (1 – DFn)/CumDFn
Where:
r(par,n) = par rate for n periods’ maturity
DFn = discount factor for n periods
CumDFn = cumulative discount factor for n periods
r(par,n)
= (1 – DFn)/CumDFn
= (1 – 1.05–2)/(1.04–1 + 1.05–2)
= 0.092970/1.868568
= 4.9755% effective annual rate
For a rising yield curve, the par rate is close to, but slightly lower than, the zero coupon rate
for the same two-year maturity (annual effective zero coupon rate = 5%).
c) Three year par rate (n = 3):
r(par,n) = (1 – DFn)/CumDFn
= (1 – 1.06–3)/(1.04–1 + 1.05–2 + 1.06–3)
= 0.160381/2.708187
= 5.9221% effective annual rate
The yield curve is rising, for this reason the par rate is slightly lower than the zero coupon rate
for the same three-year maturity (zero coupon rate = 6%).

Converting par rates to zero coupon rates

The par bond relationship is:
100 = c(1+r1)–1 + c(1+r2)–2 + …..+c(1+rn)–n + 100(1+rn)–n
The par bond relationship can also be used to calculate zero coupon rates from given par
rates. You will not be required to perform this calculation in your assessment for The context
of treasury unit.

Certificate in Treasury | 83
10 SUMMARY
In this section you have examined various yield curves including the uses and the relationships
between them and the calculations and understanding necessary to ensure that correct rates
are used for given tasks. You have looked at:
 the term structure of interest rates
 why yields differ for different maturities
 zero coupon, forward and par instruments
 zero coupon, forward and par yield curves
 the no arbitrage relationship between different yield curves
 converting forward and zero coupon rates
 zero coupon and par rates relationship

ENHANCE YOUR UNDERSTANDING

Now that you have completed this reading, review the podcast and webinars to enhance
your understanding. The podcast and webinars are accessible from your course page.

Certificate in Treasury | 84
 READING
2.5
The time value of money and
discounted cash flow
1 INTRODUCTION
Discounted cash flow (DCF) analysis is the process of discounting cash flows that are expected
in the future, to make them comparable in value with cash flows received today.
Examples where DCF is used include project evaluation and the valuation of money market
and capital market instruments.

LO9 Calculate present values of single and multiple future cash flows in
order to undertake appropriate and accurate investment appraisal.

2 IDENTIFYING WHEN CASH FLOWS OCCUR

By convention, we assume cash inflows that arise evenly over a period occur at the end of
that period.
Time n is always the end of the nth period, and Time 0 (or T0) is the start point – often now.
For example, an investment of USD 100,000 today, time 0, will repay USD 3,000 at Times 1
and 2 years, and USD 103,000 at Time 3 years.
The cash inflows and outflows for the investor are set out in Figure 1, in USD 000.

Figure 1: Cash flows

3 PRESENT VALUES AND DISCOUNTING

3.1 PRESENT VALUE FORMULA
PV = FV × (1 + r)–n
Where:
PV = Present Value, at Time 0

Certificate in Treasury | 85
FV = Future Value, or future cash flow, at Time n periods hence
r = periodic interest rate
n = the number of periods

EXAMPLE 1: Present value

Gandolf plc has an obligation to pay future pensions expected to be EUR 100m in 10 years’
time.
To achieve a pension assets target of EUR 100m in 10 years’ time, how much must Gandolf
plc invest today if the amount can be invested at 6% annual effective rate?

Solution
PV = 100 × 1.06–10
= EUR 55.84m (to the nearest EUR 0.01m)

3.2 DISCOUNT FACTORS

The number used to convert the future value into a present value is called the discount factor
(DF).
PV = FV × DF
DF = (1 + r)–n
For example the discount factor for 10 periods at a periodic yield of 6% (0.06) is:
DF = 1.06–10
= 0.5584

EXAMPLE 2: Calculating present value using the discount factor

The discount factor for 10 periods is 0.5584.
Calculate the present value of GBP 100k receivable in 10 periods’ time.
PV = FV × DF
= 100 × 0.5584
= GBP 55.84k

The ‘r’ is the interest rate, cost of capital or yield.

The greater the cost of capital, the lower the present value, and vice versa.

3.3 MULTIPLE CASH FLOWS

Imagine a series of cash flows CF1, CF2 … CFn at Time 1, 2 … n periods in the future.
Assume the same cost of capital (r) per period is suitable for discounting all of the cash flows.
The total PV is the sum of the individually discounted future cash flows:
(CF1 × DF1) + (CF2 × DF2) + ...... + (CFn × DFn)

Certificate in Treasury | 86
 EXAMPLE 3: Total present value for a series of cash flows
An investment will pay the following amounts (in USD 000):
Time (n years) Flow
1 3
2 3
3 103
Assuming an annual effective cost of capital of 4%, calculate the total present value.
The price of the investment is USD 100k.
Does this represent good value for money?

Solution
Multiply each cash flow by the respective discount factor to calculate its present value, then
add up all the present values.
Time (n years) Flow DF = 1.04–n PV at r = 0.04
1 3 1.04–1 2.885
2 3 1.04–2 2.774
3 103 1.04–3 91.567
Total USD 97.23k
This total present value is less than the purchase price of USD 100k, so the opportunity would
be rejected at an annual effective rate of 4%.

4 NET PRESENT VALUE (NPV)

NPV is the sum of the present values of incoming and outgoing cash flows, netting negative
and positive amounts.
If the net present value is negative, the proposal will be rejected.
Positive net present value proposals will be considered.

EXAMPLE 4: NPV of a series of cash flows

An investment costs EUR 100k today, and it will pay the following amounts (in EURk) at the
ends of each of the next three years:
Time (n years) Flow
1 3
2 3
3 103

Certificate in Treasury | 87
Assuming an annual effective cost of capital of 4%, calculate the total NPV of the cash flows,
including the initial investment.
Solution
Calculate each present value, then add up all the present values, netting positives and
negatives.
Time (n years) Flow in/(out) DF = 1.04–n PV at r = 0.04
0 (100) 1 (100)
1 3 1.04–1 2.885
2 3 1.04–2 2.774
3 103 1.04–3 91.567
NPV EUR (2.77)k
NPV is negative, so the opportunity would be rejected at an annual effective rate of 4%.

5 INTERNAL RATE OF RETURN (IRR) ANALYSIS

The internal rate of return (IRR) of a series of cash flows is the cost of capital that makes the
net present value of the cash flows zero.
Consider a simple example of an investment costing GBP 100m, which will repay GBP 103m in
one year’s time.
The IRR of this set of cash flows is 3% effective annual rate, as set out below

The cost of capital which makes the net present value zero is 3%.
The internal rate of return is 3%.

CALCULATING IRR BY STRAIGHT-LINE ESTIMATION

Consider the following investment opportunity (in EURk)

Certificate in Treasury | 88
The IRR of this set of cash flows lies somewhere in between 3% and 4%. At 3% the NPV is
positive EUR 2.00k, but at 4% it is negative EUR (0.77)k.

The IRR will lie somewhere between 3% and 4%, and closer to 4%.

Straight-line estimation formula

IRR estimate = a% + ((A/(A – B)) × (b% – a%))
Where:
a%, b% = two estimated costs of capital
A, B = the NPVs at each cost of capital.
Here:
a = 3%
b = 4%
A = 2.00
B = –0.77
IRR estimate = 3% + ((2/(2 – (–0.77)) × (4% – 3%))
Note: – (–0.77) = + 0.77
= 3% + ((2/2.77) × 1%)
= 3.72% (to the nearest 0.01%)
This is between 3% and 4%, and closer to 4%, as expected.

Certificate in Treasury | 89
6 ANNUITIES
Examples of annuities include fixed rate interest payments on loans, and pension payments.
The total PV of an annuity can be calculated as follows:
PV = Time 1 cash flow × (1 – (1 + r)–n )/r

EXAMPLE 5: Annuity valuation

Find the present value of a 10-year annuity of USD 6m that starts at Time 1 year in the future
and ends at Time 10 years in the future, at an annual effective cost of capital of 6%.

Solution
PV = Time 1 cash flow × (1 – (1 + r)–n)/r
= USD 6m × (1 – 1.06–10)/0.06
= USD 6m × 7.3601
= USD 44.16m

Annuity factor
It is often easier to bundle up the calculation:
(1 – (1 + r)–n)/r
into one item, the Annuity Factor (AF) or ‘annuity formula’.
PV = Time 1 cash flow × AF
For example, if the Time 1 cash flow = USD 6m and the annuity factor AF = 7.0236:
PV = 6 × 7.0236
= USD 42.14m.

EXAMPLE 6: Yield to maturity (IRR) of a redeemable bond

A ten-year bond pays an annual coupon of 6% and is trading at 98% of its face value. We want
to calculate the yield to maturity, i.e. the yield quoted in the market for the bond. To do this
we calculate the IRR of the bond cash flows.
This is done by calculating the net present value at two different guessed yields.
The periodic coupon per 100 nominal value is 6% × 100 = 6.
We will use 6% and 7% as our guesses for the yield.
T years Amount AF/DF 6% PV 6% AF/DF 7% PV 7%
0 (98) 1.0000 (98) 1.0000 (98)
1-10 6 7.3601 44.16 7.0236 42.14
10 100 0.5584 55.84 0.5083 50.83
NPV 2.00 – 5.03

Certificate in Treasury | 90
The annuity factors (AF) are calculated as (1 – 1.06–10)/0.06 = 7.3601 and
(1 – 1.07–10)/0.07 = 7.0236
The discount factors (DF) are calculated as 1.06–10 = 0.5584 and 1.07–10 = 0.5083
The NPVs are + 2.00 and – 5.03 at 6% and 7%.
Using straight-line estimation.
IRR estimate = 6% + ((2/(2 – (–5.03)) × (7% – 6%))
= 6 + ((2.00/7.03) × 1)
= 6.28%

7 PERPETUITIES
Suppose the periodic cash flows are all the same and that they go on forever so that n = ∞
(infinity). This is a perpetuity.
The present value of a perpetuity can be calculated using the perpetuity formula:
PV = Time 1 cash flow/r
Where:
PV = the present (Time 0) value of the fixed perpetuity starting at Time 1 period hence
r = the periodic cost of capital, being the same for all maturities from Time 1 to infinity.

EXAMPLE 7: Present value of fixed perpetuity

An investment will pay GBP 3m per year in perpetuity, starting at Time 1 year in the future.
Calculate the present value, using 3% annual effective rate.

Solution
PV = Time 1 cash flow/r
= GBP 3m/0.03
= GBP 100m
To enjoy a perpetual fixed annual income of GBP 3m, when yields are 3%, the investor must
invest GBP 100m.

7.1 DEFERRED PERPETUITIES

If a perpetuity starts later than Time 1 period in the future, for example at Time 4 or Time n+1,
the total present value is smaller than for a perpetuity starting at Time 1.
Take the example of a perpetuity starting at Time 4.
Rolling forward the standard present value formula by three periods:
PV(Time 0) = Time 1 cash flow/r
future value = FV(Time 3) = Time 4 cash flow/r

Certificate in Treasury | 91
To calculate the present, we need to discount the future value at Time 3 (T3), by three periods:
PV = FV(Time 3) × DF3
Where:
DF3 = discount factor for 3 periods’ maturity
Say the perpetuity is GBP 3m per year, and the annual effective cost of capital is 3%.
FV(T3) = 3/0.03
= GBP 100m
PV = 100 × 1.03–3
GBP 91.51m

7.2 GROWING PERPETUITIES

A growing perpetuity is a series of payments (or receipts) that grow at a constant periodic rate
and last forever.
Their present value is greater than a fixed perpetuity, because of the growth.
PV = Time 1 cash flow/(r – g)
Where:
g = the expected constant future periodic rate of growth of the cash flow from Time 1

EXAMPLE 8: Growing perpetuity

An investment is expected to pay out USD 3m per year, starting at Time 1 year, growing at 1%
per year in perpetuity.
Use an annual effective cost of capital of 3% to calculate the present value of this investment.
PV = Time 1 cash flow/(r – g)
= 3/(0.03 – 0.01)
= 3/0.02
= USD 150m

A substantial part of the total present value results from the growth, even at quite modest
rates of growth.

8 REAL TERMS EVALUATIONS

One component of growth is inflation.
Real terms figures strip out the effects of inflationary growth, to identify ‘real’ (inflation
adjusted) cash flows and real rates of return.
For example, if the nominal annual effective rate of return is 3%, and inflationary growth is
1%, the real rate of return is just under 2%, calculated as:
real rate of return = ((1 + nominal rate)/(1 + inflationary growth rate)) – 1

Certificate in Treasury | 92
= (1.03/1.01) – 1
= 0.019802
= 1.9802%
The result is slightly less than 2%, because of the compounding together of the real rate and
the inflationary growth (1.019802 × 1.01) = 1.03 – 1 = 3%.

8.1 REAL TERMS CASH FLOWS

The real terms equivalent of a future cash flow is calculated by discounting it at the
inflationary growth rate.
real terms cash flow = future cash flow × (1 + g)–n
Where:
g = inflationary growth rate per period
n = number of periods

EXAMPLE 9: Real terms cash flow

A future cash flow is EUR 3m, expected at Time 1 year in the future.
Inflationary growth is 1% per year.
Calculate the real terms equivalent of this future cash flow.

Solution
real terms cash flow = future cash flow × (1 + g)–n
= 3 × 1.01–1
= EUR 2.9703m

8.2 REAL TERMS EVALUATIONS WORK IN THEORY

In theory real terms evaluations will give the same result as evaluations made in nominal
terms.
For example, with a perpetuity growing at 1% per period, with the first cash flow being EUR
3m in one period’s time, and a nominal annual effective rate of return of 3%:
real rate of return = (1.03/1.01) – 1 = 0.019802
real terms fixed cash flow starting Time 1 = 3 × 1.01–1 = EUR 2.9703m
Working in real terms, the present value of the fixed real terms perpetuity is given by:
PV = cash flow Time 1/r
= real terms cash flow Time 1/real rate of return
= 2.9703/0.019802
= EUR 150m
This is the same result as the nominal terms calculation 3/(0.03 – 0.01) = 150.

Certificate in Treasury | 93
Why real terms evaluations can be useful
They can help us to identify and think separately about the components of expected total
money amounts driven by expected inflation rates.
They may also be useful in certain simplified modelling situations, for example where future
pension payments are modelled as growing at an expected constant rate of growth per period.

8.3 WHY NOMINAL TERMS EVALUATIONS ARE USUALLY PREFERABLE

Not all money amounts grow at the same rates. Indeed some money amounts become smaller
over time, and some remain more or less constant.
Using simplistic single figures for inflation adjustments can mask this important level of detail
in forecasting.
Working in nominal money terms may assist in focusing on this important factor.

9 SUMMARY
In this reading you have seen how to identify when cash flows occur and to calculate the
present values of single and multiple future cash flows in order to undertake accurate and
appropriate investment appraisal. You have looked at:
 present values and discounting
 net present value
 internal rate of return
 annuities
 perpetuities
 real terms evaluations

Certificate in Treasury | 94
 SELF-ASSESSMENT
2.6
Study session 2 exercises
Use these exercise questions to assess your understanding of the learning outcomes of
this study session.

You should also try this study session’s online progress test which is a short multiple-
choice test designed to assess your grasp of key concepts.

QUESTIONS
QUESTION 1
LO5
If the average forecast borrowings for a company are USD 200m and the expected annual
effective interest rate is 3%, calculate the forecast annual interest expense.

QUESTION 2
LO5
You are the treasurer for D Inc. (D) reporting to the finance director about any favourable or
adverse variances between your forecast and budgeted cash flows.
D’s forecast cash flow, before interest expense, is USD 20m.
D’s expected interest expense is USD 4m, and its budgeted cash flow after interest is USD
17m.
Calculate the favourable or adverse variance in cash flow after interest, compared with the
budgeted figure.

QUESTION 3
LO5
GBP 1 = EUR 1.2000 (GBP/EUR = 1.2000)
Calculate the EUR equivalent of GBP 50m.

QUESTION 4
LO5
EUR 1 = USD 1.2500 (EUR/USD = 1.2500).
Calculate the EUR equivalent of USD 200m.

QUESTION 5
LO5
Calculate: a) the appropriate discount factor and b) the present value of EUR 100m due in 2
periods’ time.
The periodic rate of return is 1% (0.01).
Certificate in Treasury | 95
QUESTION 6
LO5
You are a cash manager and you are considering making a short-term deposit of EUR 100,000
for 270 days at a quoted rate of 6.00%.
Calculate the total amount payable at the maturity of the deposit.

QUESTION 7
LO5
You are a group cash manager and your assistant has invested USD 550,000 for 60 days at a
quoted rate of 5.50%.
Calculate the total amount payable at maturity of the deposit.

QUESTION 8
LO6
Your predecessor entered a loan agreement which charges penalty interest on any arrears
outstanding at an interest rate of 0.10% per day.
Calculate the effective annual rate (EAR).

QUESTION 9
LO6
A deposit offers 0.4080% interest per month.
a) Calculate its EAR.
b) If another deposit offered 1.2240% interest per quarter, what would be the EAR?
c) Which deposit has the better annual effective rate of return?
d) Calculate the total benefit of investing GBP 100m in the higher-returning deposit for
a year, assuming you reinvest the maturing proceeds at the same rates throughout
the whole year. Give your answer to the nearest GBP 1,000.
QUESTION 10
LO6
Your assistant is unsure about how nominal annual rates are quoted in the market. Explain for
your assistant the amount that a corporate customer’s GBP 100,000, 270-day deposit will pay
at maturity if a bank’s quote is 6.00%-6.10%.

QUESTION 11
LO7
You are considering investing a short-term cash surplus of GBP 10,000,000 in a money market
deposit with a maturity of 30 days, quoted at a yield of 6.25%.
Calculate the amount payable at maturity.

QUESTION 12
LO7
Your assistant has made a money market deposit of EUR 15,000,000 for 183 days, which will
repay EUR 15,421,875 at maturity.
Calculate the related periodic yield and nominal annual yield.

Certificate in Treasury | 96
QUESTION 13
LO7
Your company has issued a USD discount instrument with a face value (i.e. redemption value)
of USD 5,000,000 and a maturity of 45 days at a quoted discount rate of 4.50%.
Explain for the benefit of your new assistant the discount amount deducted at the time of
issue, and hence the issue proceeds, illustrating your explanation with the figures in this
question.

QUESTION 14
LO7
An instrument with a market issue price of GBP 12,000,000 is issued with a maturity of 91
days, when it will return GBP 12,217,000.
The instrument is quoted on a discount basis.
Calculate the periodic discount rate and the nominal annual discount rate.

QUESTION 15
LO7
Your company has issued a GBP discount instrument with a maturity of 1 year with a quoted
discount rate of 5.19%.
a) Calculate the nominal annual yield for this instrument.
b) Explain for the benefit of your new assistant why the nominal annual yield is greater
than the quoted discount rate.
QUESTION 16
LO7
You have a choice between investing USD in the following two instruments.
a) Which gives the better EAR?
Instrument A Instrument B
Time to maturity 60 days 70 days
Currency USD USD
Quotation basis Yield Discount
Quotation (nominal annual) 5.25% 5.24%
b) What additional key factor should be considered when comparing these two
instruments?
QUESTION 17
LO7
Your company has bought a USD discount instrument with a face value (i.e. redemption price)
of USD 2,500,000 and a remaining maturity of 5 days with a quoted discount rate of 3.60%.
Calculate the discount amount, current market price and nominal annual yield for this
instrument.

Certificate in Treasury | 97
QUESTION 18
LO7
Your company has invested in certificates of deposit (CDs).
Calculate the EAR of an 8.00% nominal annual yield quoted for a 91-day GBP CD.

QUESTION 19
LO7
Your company has borrowed using coupon paying bonds with quarterly coupons.
Calculate the EAR of a bond paying a nominal annual 6.00% coupon, paid quarterly.

QUESTION 20
LO7
Your company has invested in an EUR money market instrument, quoted on a discount basis.
Calculate the EAR of an EUR instrument with a nominal annual discount rate of 4.80% and a
maturity of 181 days.

QUESTION 21
LO7
Your company has borrowed using a discount instrument with a face value of USD 1,000,000,
a maturity of 45 days and a nominal annual discount rate of 4.50%.
Calculate the issue proceeds for your company.
a) USD 994,375
b) USD 994,400
c) USD 994,450
d) USD 994,480
QUESTION 22
LO7
Your company has invested in a 180-day discount instrument with a face value of USD 100,000
at a discount rate of 6.00%.
Calculate the effective annual return on this instrument, to the nearest 0.01%.
a) 6.37%
b) 6.28%
c) 6.18%
d) 6.09%
e) 5.91%
QUESTION 23
LO8
Explain, for the benefit of a new intern, what a yield curve shows and how it is constructed.

QUESTION 24
LO8
Describe par rates and explain their usefulness.

Certificate in Treasury | 98
QUESTION 25
LO8
Explain briefly zero coupon rates and their usefulness for treasurers and distinguish zero
coupon rates from par rates.

QUESTION 26
LO8
Describe the meaning and usefulness of forward rates, and explain the link between forward
rates, zero coupon rates and par rates.

QUESTION 27
LO8
Today’s quoted short-term (nominal annual) GBP zero coupon rates are:
Maturity Short-term GBP zero coupon yield
0-3 months 4%
0-6 months 4%
0-9 months 4%

a) Set out the cash flows for the related zero coupon instruments, assuming an initial
investment of GBP 1,000,000 in each case.
b) Calculate the periodic yields for the periods 3-6 months and 6-9 months, from the
cash flows at 3, 6 and 9 months respectively (calculated in a)).
c) Calculate the nominal annual yields for the periods 3-6 months and 6-9 months, from
the periodic yields for the 3-month forward periods, (calculated in b)).
QUESTION 28
LO8
Today’s short-term GBP forward yield curve is quoted as:
Maturity Quoted forward yield
0-3 months 4%
3-6 months 4%
6-9 months 4%
a) Set out the cash flows for the related forward instruments, assuming an initial (Time
0) investment of GBP 1,000,000, with re-investment of the maturing proceeds in the
later periods.
b) Calculate the periodic yields for the periods 0-6 months and 0-9 months, from the
cash flows at 6 and 9 months respectively (calculated in a)).
c) Calculate the nominal annual yields for the periods 0-6 months and 0-9 months, from
the periodic yields for the 6-month and 9-month zero coupon periods, (calculated in
b)).

Certificate in Treasury | 99
QUESTION 29
LO8
Given the periodic zero coupon rates set out in the table, calculate the related par rates for
maturities of
a) one period
b) two periods
c) three periods
Period ZCR
1 5%
2 6%
3 7%

QUESTION 30
LO9
Define the following key concepts in discounted cash flow (DCF) analysis:
a) present value
b) future value
c) discounting
d) discount factors
QUESTION 31
LO9
Calculate the present value of USD 50,000 receivable two years from now, discounted at an
annual effective rate of 5.00%.

QUESTION 32
LO9
a) Calculate the present value of EUR 1,000m receivable 90 days from now, discounted
at:
i. an annual effective rate of 4.50%
ii. a nominal annual yield of 4.50%

b) Explain why the value calculated in part ii) is lower than the value in part i).
QUESTION 33
LO9
The annual effective rate of return for two years’ maturity is 10%.
Calculate the related discount factor, to the nearest 0.0001.

QUESTION 34
LO9
Your company is considering investing in a new project.
The following amounts (in GBPm) are expected to be received at the end of each of the next
three years respectively: 100, 110, 120.

Certificate in Treasury |100

Calculate the total present value of these cash flows for the purposes of evaluating the
project.
Use an annual effective cost of capital of 5.00% for all maturities.

QUESTION 35
LO9
Which statement is false?
a) The present value of a future cash flow is its money amount multiplied by the
appropriate discount factor.
b) The internal rate of return (IRR) of a series of cash flows is the cost of capital that
makes the net present value of the cash flows equal to zero.
c) The annuity formula provides a short cut to finding the present value of a finite series
of identical cash flows using the same periodic cost of capital for all maturities.
d) The growing perpetuity formula provides a short cut to finding the present value of
an infinite series of identical cash flows using a periodic cost of capital that is growing
at a constant rate.
QUESTION 36
LO9
Calculate the present value of USD 121,000 receivable in two years from now, given an annual
effective cost of capital of 10.00%.
a) USD 100,000
b) USD 100,833
c) USD 102,234
d) USD 110,000
QUESTION 37
LO9
Your company is due to start paying lease instalments with a total present value of USD 10m
in 5 equal annual instalments, starting in one year’s time.
The annual effective interest rate implied by the lease instalments and the total present value
is 6.00%.
Calculate the amount of each lease instalment, to the nearest USD 1,000.
a) USD 2,060,000
b) USD 2,120,000
c) USD 2,240,000
d) USD 2,374,000
e) USD 2,676,000
QUESTION 38
LO9
a) For the benefit of a new treasury analyst, define net present value (NPV) and internal
rate of return (IRR).
b) Explain the usefulness of NPV analysis and IRR analysis.

Certificate in Treasury |101

QUESTION 39
LO9
A proposed investment is expected to produce annual net cash inflows of USD 1m for 20 years,
starting in one year’s time.
Use an annuity factor to calculate the total present value of these cash flows.
The annual effective cost of capital is 4.25%.

QUESTION 40
LO9
Calculate the present value of an investment that is expected to produce net cash inflows of
EUR 1.5m a year, starting in one year’s time, with 2% growth per year in perpetuity, given an
annual effective cost of capital of 6%.

QUESTION 41
LO9
An investment is expected to pay out in perpetuity, with the first payment of EUR 5,000 now,
and subsequent payments growing at a rate of 3% per annum.
Using annual effective cost of capital of 10%, calculate the total present value of this
investment.

QUESTION 42
LO9
An investment is expected to pay out in perpetuity, with the first payment of EUR 5,150 in
one year’s time, and subsequent payments growing at a forecast inflation rate of 3% per
annum.
The annual effective cost of capital is 10%.
a) Calculate a ‘real terms’ adjusted cost of capital, stripping out the inflation growth rate
of 3% per annum from the money cost of capital of 10% annual effective rate.
b) Calculate the real terms equivalent of the first payment of EUR 5,150 in one year’s
time.
c) Evaluate the investment using the fixed perpetuity formula and your real terms
figures from parts a) and b).

ANSWERS
ANSWER 1
The interest expense = average borrowings × periodic interest rate
= USD 200m × 3%
= 200 × 0.03
=6
So the forecast interest expense is USD 6m.

Certificate in Treasury |102

ANSWER 2
The company’s forecast cash flow after interest expense is: 20 – 4 = USD 16m
The budgeted cash flow is USD 17m
Therefore the forecast cash flow is worse than the budgeted figure of USD 17m, by USD 1m:
17m – 16m = USD 1m
This is an adverse variance.

ANSWER 3
GBP 50m × 1.2000 = EUR 60m
The EUR equivalent of GBP 50m is EUR 60m.

ANSWER 4
USD 200m/1.2500 = EUR 160m
The EUR equivalent of USD 200m is EUR 160m.

ANSWER 5
a) Using the discount factor (DF) formula:
DFn,r = (1 + r)–n
DF2,0.01 = (1 + 0.01)–2
= 1.01– 2
= 0.9803
b) Using the present value (PV) formula:
PV = FV × DF
Where FV = Future Value
PV = EUR 100m × 0.9803
= EUR 98.03m

ANSWER 6
Short-term EUR interest is quoted on an act/360 days basis.
The simple interest in EUR, based on the short-term nominal annual rate R is given by:
interest = principal × R × days/year
= EUR 100,000 × 0.06 × 270/360
= EUR 4,500
The total principal and interest payable at maturity is:
100,000 + 4,500
= EUR 104,500

Certificate in Treasury |103

Short calculation
Alternatively using a single calculation for the total of principal plus interest repayable:
EUR 100,000 × (1 + (0.06 × 270/360))
= EUR 104,500
This is the total amount payable at maturity of the deposit.

On the calculator
Using the recommended Casio FX85 calculator, for the second version of the calculation
above, key in:
100000 × (1 + (0.06 × 270 ÷ 360)) =

ANSWER 7
Using a single calculation for the return of the principal plus simple interest:
maturity amount = principal × (1 + R × days/year)
= USD 550,000 × (1 + (0.055 × 60/360))
= USD 555,042

On the calculator
Key in:
550000 × (1 + (0.055 × 60 ÷ 360)) =

ANSWER 8
The periodic yield (r) = 0.1% = 0.001
n = 365 (days per calendar year)
The EAR is:
(1 + r)n – 1
= 1.001365 – 1
= 0.440251
= 44.0251%

On the calculator
We need to use the ‘power’ button.
This button is shown differently on different calculators, but they all perform the same
function ‘raise to the power of’. For example:
[ ×□ ]
[ ^ ] or

Certificate in Treasury |104

[ ×y ]
On the Casio FX 85 calculator, key in:
1.001 [×□] 365 ) – 1 =

This will display as:

1.001^(365) – 1
0.4402513134

This is 44.0251%, to the nearest 0.0001%.

ANSWER 9
a) r = 0.408% = 0.00408
n = 12 (months per calendar year)
EAR = 1.0040812 – 1
= 0.050074
= 5.0074%
b) r = 0.01224
n = 4 (quarters per calendar year)
EAR = 1.012244 – 1
= 4.9866%
c) The monthly-interest deposit has the better rate of return.
This is because the same nominal annual rate of interest is compounded more frequently.
(The nominal annual rate is the same in both cases: 12 × 0.408% = 4.896% = 4 × 1.224%.)
d) The EAR gives the total of rolled-up interest at the end of a year, assuming reinvestment of
the maturing proceeds of the shorter-term investment.

Using the results in a) and b)

Total interest from monthly deposits:
EAR × principal at start of year
= 0.050074 × 100,000,000
= GBP 5,007,400
From quarterly deposits:
= 0.049866 × 100,000,000
= GBP 4,986,600
benefit = 5,007,400 – 4,986,600
= GBP 20,800
Certificate in Treasury |105
To the nearest GBP 1,000 this is GBP 21,000.

Short calculation to minimise rounding differences

(1.0040812 – 1.012244) × 100,000,000
= GBP 20,748
To the nearest GBP 1,000, this is GBP 21,000.

On the calculator
It is easiest to work out the (1.0040812 – 1.012244) separately first.
On the Casio FX 85 calculator, key in:
1.00408 [×□] 12) – 1.01224 [×□] 4) =
This will display as:
1.00408^(12) – 1.01224^(4)
0.00020747915

Then multiply this result by 100,000,000, to calculate 20,748, to the nearest GBP 1.

ANSWER 10
The maturity amount will be GBP 104,438.

Explanation
The customer will always take the worse side of any two-way quote.
In this case the corporate will deposit at the less favourable side of the quote for receiving
interest, namely 6.00%. (This is sometimes known as the bank ‘bid’ rate. It is the rate at which
the bank ‘bids’ for deposits from customer.)
Short-term GBP interest is quoted on a simple actual/365 days basis.
So the return of principal plus simple interest for 270 days at 6.00% nominal annual rate:
GBP 100,000 × (1 + (0.06 × 270/365))
= GBP 104,438

ANSWER 11
Yield is calculated and quoted on the same basis as interest.
Yield is the amount added to an initial amount invested, in order to calculate the maturity
amount (also known as the ‘terminal value’).
Maturity amount:
GBP 10,000,000 × (1 + (0.0625 × 30/365))
= GBP 10,051,370

Certificate in Treasury |106

ANSWER 12
Periodic yield:
r = (end cash/start cash) – 1
= (15,421,875/15,000,000) – 1
= 0.028125
= 2.8125% per 183-day period
Nominal annual yield (EUR 360-day conventional year):
R = r × (year/days)
= 2.8125% × (360/183)
= 5.5328%

Short calculation
Alternatively calculating both steps together, and minimising any rounding differences:
R = ((15,421,875/15,000,000) – 1) × (360/183)
= 5.5328%

ANSWER 13

How discount instruments are quoted

Discount is an amount deducted from the maturity amount (also known as terminal value,
face value, or redemption value) to calculate the issue proceeds at the start.
Short-term discount rates are calculated and quoted as a proportion of the maturity amount,
in this case USD 5,000,000.

Discount amount
The discount amount deducted at the time of issue will be:
USD 5,000,000 × (0.045 × 45/360)
= USD 28,125

Issue proceeds
So, the issue price of the discount instrument is:
USD 5,000,000 – USD 28,125= USD 4,971,875

ANSWER 14

Discount amount
discount amount = maturity amount – issue price
= 12,217,000 – 12,000,000
= 217,000

Certificate in Treasury |107

Periodic discount rate
d = discount/maturity amount
= 217,000/12,217,000
= 1.7762% per 91 days

Nominal annual discount rate (GBP 365-day conventional year)

d × (year/days)
= 1.7762% × (365/91)
= 7.1243%

Short calculation
Alternatively, all in one calculation, avoiding rounding differences:
((12,217,000 – 12,000,000)/12,217,000) × (365/91)
= 7.1244%

ANSWER 15
a) We can use the formula:
r = d / (1 – d)
Where:
r = periodic yield
d = periodic discount rate
In this case, the length of one period is one year, so:
periodic discount rate = nominal annual discount rate
= 0.0519 per year
r = 0.0519/(1 – 0.0519)
= 0.0519/0.9481
= 5.47% nominal annual GBP yield.
This is the nominal annual yield for compounding once per year, so it is also the annual
effective yield.
b) Yields are generally larger numbers than the related discount rates.
This is because of the difference in the way yields and discount rates are quoted.
The yield is quoted based on the amount at the start (for -example 1 – 0.0519 = 0.9481).
The discount rate is quote based on the amount at the end (= 1).
In this case:
yield = 0.0519/0.9481 = 5.47%
discount rate = 0.0519/1 = 5.19%
Certificate in Treasury |108
ANSWER 16
a) Both instruments are USD, so the nominal annual quotes are based on a 360-day year.
EAR is based on calendar years, 365 days assuming it is not a leap year.

Instrument A, quoted on a yield basis

Nominal annual yield R = 0.0525
Periodic yield (r)
= 0.0525 × 60/360
= 0.00875
n = number of times the period fits into a calendar year
= 365/60
EAR = (1 + r)n – 1
= 1.00875(365/60) – 1
= 5.4427%

Instrument B, quoted on a discount basis

periodic discount rate (d)
= 0.0524 × 70/360
= 0.0101889
periodic yield (r) = d/(1 – d)
= 0.0101889/(1 – 0.0101889)
= 0.0102938
EAR = 1.0102938 (365/70) – 1
= 5.4852%
Instrument B has the greater EAR.
(This is mainly because it is quoted on a discount basis, which generally results in a greater
EAR.)
b) Risk is always the most important factor. Maturity is also relevant here, as one instrument
has 60 days’ maturity, and the other 70 days’ maturity.

ANSWER 17

Discount amount
discount amount = terminal value × nominal annual discount rate × days/year
USD 2,500,000 × 0.036 × 5/360
= USD 1,250 discount amount
USD 2,500,000 – USD 1,250

Certificate in Treasury |109

= USD 2,498,750 market price

Periodic yield (r)

= (end cash/start cash) – 1
end cash = terminal value = 2,500,000
start cash = market price = 2,498,750
r = (2,500,000/2,498,750) – 1
= 0.00050025
= 0.050025% per 5 days

Nominal annual yield (R) USD

= r × (year/days)
= 0.050025% × (360/5)
= 3.6018%

ANSWER 18

Step 1
8% GBP nominal annual yield to periodic yield per 91 days:
= 0.08 × (91/365)
= 0.019945 per 91-day period

Step 2
91-day periodic yield to EAR:
1.019945(365/91) – 1
= 8.2434%

ANSWER 19

Step 1
6% quarterly nominal annual rate to quarterly periodic yield:
6% × 1/4
= 0.015 per 3-month period

Step 2
Periodic yield per 3 months to EAR:
1.0154 – 1
= 6.1364% EAR

Certificate in Treasury |110

ANSWER 20

Nominal annual EUR discount rate (D) to periodic discount rate (d)
d = D × days/year
0.048 × 181/360
= 0.024133 per 181-day period.

Periodic discount (d) rate to periodic yield (r)

r = d/(1 – d)
0.024133/(1 – 0.024133)
= 0.024730 yield per 181-day period

Periodic yield (r) to EAR

1.024730(365/181) – 1
= 5.0497% EAR

ANSWER 21
a) USD 994,375.

Workings
The discount amount deducted at the time of issue is:
USD 1,000,000 × 0.045 × 45/360
= USD 5,625
So, the issue proceeds of the discount instrument are:
USD 1,000,000 – USD 5,625
= USD 994,375

ANSWER 22
a) 6.37%.

Periodic USD discount rate (d)

= nominal annual discount rate D × actual days/360
= 0.06 × 180/360
= 0.03 per 180 days

Periodic discount rate to periodic yield (r):

= d/(1 – d)
= 0.03/(1 – 0.03)
= 0.0309278 per 180 days

Certificate in Treasury |111

EAR
= 1.0309278(365/180) – 1
= 6.3712% which rounds to 6.37%

ANSWER 23
Market interest rates for otherwise comparable instruments of different maturities usually
differ, depending on the maturity of the instrument.
The yield curve shows how market rates change for comparable instruments as the maturity
increases.
Normally yield curves are plotted using the market rates and maturities of government issued
debt.
The relationship between prevailing market rates and the maturity of the instrument is known
as the yield curve, or the term structure of interest rates.
When there is a difference between market rates for different maturities, the exact pattern
of cash flows in the quoted market instrument is also important.
Three important different classes of market interest rate (yield) are par, zero coupon and
forward rates.

ANSWER 24
The par yield curve plots the coupon rates of coupon paying bonds of equivalent credit risk all
of which are trading at ‘par’, i.e. at their face value, but each of which has a different maturity.
Because these bonds are trading at par, this is also a plot of the yield on those bonds.
Coupon paying bonds have multiple cash flows, namely periodic coupon payments, together
with eventual repayment of principal.
Par rates are used for determining:
 the coupon rate on a new bond redeemable at par, for it to be issued successfully at its
par value
 the fixed leg rate of a new interest rate swap (swap pricing)
 par rates are also known as ‘swap rates’ because of their use in interest rate swap pricing.

ANSWER 25
Zero coupon rates relate to single future cash flows, for example the maturity amounts of zero
coupon bonds.
Zero coupon bonds pay no intermediate interest, only a single principal and interest amount
at their final maturity.
Zero coupon rates can be calculated from par rates, using a process known as ‘bootstrapping’.
The only correct method of valuing future cash flows is to discount each separate future cash
flow using the appropriate zero coupon rate for the maturity and currency of the respective
cash flow.

Certificate in Treasury |112

ANSWER 26
Forward rates are rates available in the market today, which can be contractually committed
in relation to future deposits or borrowings.
Forward rates are used for determining:
 historically ‘forward forward’ rates for physical deposits or borrowings
 the rates for related derivative instruments, known as ‘forward rate agreements’ (FRAs)
 forward interest rates also provide the best available current market information about
the market’s expectations of future out-turn interest rates.

This is known as ‘expectations theory’.

The yield curve for instruments of a given risk can be expressed as a zero coupon yield curve,
a forward yield curve or a par yield curve.
If any one set of rates (zero coupon, forward or par) is known, then each of the other two
related yield curves can be calculated from it.

ANSWER 27
a) Amounts returned to investors of GBP 1,000,000, all initially invested at Time 0 months, for
different short-term periods, all at nominal annual rates of 4% = 0.04.
For periods of i) 0-3 months, ii) 0-6 months and iii) 0-9 months, all in GBP:
i) 1,000,000 × (1 + (0.04 × 3/12)) = 1,010,000
ii) 1,000,000 × (1 + (0.04 × 6/12)) = 1,020,000
iii) 1,000,000 × (1 + (0.04 × 9/12)) = 1,030,000
b)
Periodic yield (r):
= (end cash/start cash ) – 1
i)
r(3-6) = (1,020,000/1,010,000) – 1
= 0.009901
= 0.9901% for the 3-month period 3-6 months
ii)
r(6-9) = (1,030,000/1,020,000) – 1
= 0.9804% for the 3-month period 6-9 months
c)
The periods are both 3 months long, so in each case the conversion from the 3-month periodic
rate (r) to the simple interest nominal annual rate (R) is × 12/3 months.
i) 0.9901% × 12/3 = 3.9604% nominal annual rate for 3-6 months’ maturity.
ii) 0.9804% × 12/3 = 3.9216% nominal annual rate for 6-9 months’ maturity.

Certificate in Treasury |113

ANSWER 28
a) Amounts returnable to an investor who initially invested GBP 1,000,000 at Time 0 months,
with successive reinvestment for further different short-term periods of 3 months’ maturity
each, all at nominal annual rates of 4%.
Cumulative amounts at the end of i) 3 months, ii) 6 months and iii) 9 months, all in GBP:
i) 1,000,000 × (1 + (0.04 × 3/12)) = 1,010,000 at Time 3 months
(Note the nominal annual ‘forward’ rate r(0-3) of 4% gives exactly the same result of 1,010,000
as the nominal annual zero coupon rate r(0-3) of 4%. This is because they represent identical
deals and cash flows. Both deals are to pay away cash at Time 0 months, and receive more
cash back at Time 3 months in the future.)
ii) Reinvesting the maturing proceeds at Time 3 months, for a further 3 months:
1,010,000 × (1 + (0.04 × 3/12)) = 1,020,100 (at Time 6 months)
iii) 1,020,100 × (1 + (0.04 × 3/12)) = 1,030,301 (at T = 9 months)
b) Periodic yield (r):
= (end cash/start cash) – 1
i)
r(0-6) = (1,020,100/1,000,000) – 1
= 0.0201
= 2.01% for the 6-month period 0-6 months
ii)
r(0-9) = (1,030,301/1,000,000) – 1
= 3.0301% for the 9-month period 0-9 months
c)
i) The 0-6 months period is 6 months long, so the conversion from the periodic rate (r) to the
nominal annual rate (R) is × 12/6 months:
2.01% × 12/6 = 4.02% nominal annual rate for 0-6 months’ maturity.
ii) However, the 0-9 months’ period is 9 months long, so in this case the conversion from the
periodic rate (r) to the nominal annual rate (R) is × 12/9 months:
3.0301% × 12/9 = 4.0401% for 0-9 months’ maturity.

ANSWER 29
a) The one-period par rate is the same as the one-period zero coupon rate, because both rates
represent the identical market deal.
b) The two-period par rate (n = 2 periods) is calculated using the formula:
r(par,n) = (1 – DFn)/CumDFn
Where:
r(par,n) = par rate for n periods maturity
Certificate in Treasury |114
DFn = discount factor for n periods
CumDFn = cumulative discount factor for n periods
r(par,n)
= (1 – DFn)/CumDFn
= (1 – 1.06–2)/(1.05–1 + 1.06–2)
= 0.1100036/1.842377
= 5.9707%.
For a rising yield curve, the par rate is close to, but slightly lower than, the zero coupon rate
for the same maturity (6%).
c) Three-period par rate (n = 3):
r(par,n) = (1 – DFn)/CumDFn
= (1 – 1.07–3)/(1.05–1 + 1.06–2 + 1.07–3)
= 0.1837021/2.658675
= 6.9095%.
Rising yield curve, par rate slightly lower than zero coupon rate for same maturity (7%).

ANSWER 30
Key concepts in Discounted Cash Flow analysis:
a) The present value of a future cash flow means the amount payable today in order to obtain
the entitlement to receive the future sum. In a simple situation this can be calculated as the
amount of a deposit to be made today, which would grow into the required future cash flow,
by the fixed future date.
b) The future value means the amount of the cash flow expected at a given future date.
c) Discounting means the mathematical process of converting future cash flows into
equivalent present values, in order to enable meaningful comparisons to be made between
them.
d) The process of discounting involves multiplying the future cash flow by an appropriate
number known as a discount factor. Discount factors are calculated in turn based on the time
difference between today and the future cash flow, and the relevant cost of capital for the
related period. The relevant cost of capital may be, for example, a market interest rate.

ANSWER 31
Using the present value (PV) formula:
PV = future cash flow × discount factor
= USD 50,000 × 1.05–2
= USD 45,351

Alternatively
USD 50,000/1.052 = USD 45,351

Certificate in Treasury |115

ANSWER 32
i) EAR = 0.045
discount factor (DF) = (1 + r)–n
Where:
r = periodic rate
= 0.045 per year (EAR)
n = number of times maturity fits into period for which periodic rate (r) is given
= 90/365 (calendar years for EAR)
PV = 1,000 × DF
DF = 1.045–(90/365)
PV = 1,000 × 1.045–(90/365)
= EUR 989.21m
(To the nearest EUR 0.01m.)
ii) nominal annual rate (R) = 0.045
year = 360 days for EUR.
Periodic rate per 90 days:
r = R × days/year
= 0.045 × 90/360
= 0.01125 per 90-day period
PV = 1,000 × DF
DF = 1.01125–1
PV = 1,000 × 1.01125–1
= EUR 988.88m
b) The value in part ii) has been discounted more heavily.
The nominal annual 90-day EUR rate of 4.50% used in part ii) is a higher effective rate than
the EAR of 4.50% in part i).
(The EAR in part ii) is 1.01125(365/90) – 1 = 4.64% to the nearest 0.01%).

ANSWER 33
DF = (1 + r)–n
= 1.10 –2
= 0.8264

Certificate in Treasury |116

ANSWER 34
The total present value for this series of cash flows is:
Time (n years) Flow (GBP m) x DF (1 + r)–n = PV (at r = 0.05)
1 100 1.05–1 = 0.9524 95.24
2 110 1.05–2 = 0.9070 99.77
3 120 1.05–3 = 0.8638 103.66
GBP 298.67 m

ANSWER 35
d) The growing perpetuity formula provides a short cut to finding the present value of an
infinite series of cash flows increasing at a constant growth rate using the same periodic cost
of capital for all maturities. Therefore statement d) is false.
The other statements are all true.

ANSWER 36
a) USD 100,000.

Workings
Using the present value formula:
121,000 × 1.10–2
= USD 100,000.

ANSWER 37
d) USD 2,374,000.

Workings
Let the lease instalment to be calculated = L
The lease instalments are a five-period fixed annuity, the first cash flow being at Time 1.
The total present value is USD 10m.

Using the annuity valuation formula

present value (PV) = Time 1 cash flow × annuity factor (AFn,r )
Where:
AFn,r = the annuity factor for n periods maturity, at a periodic yield of r
AFn,r = (1 – (1 + r)–n)/r
PV = USD 10m = L × AF5,0.06
AF 5,0.06 = (1 – 1.06–5)/0.06
= 4.21236

Certificate in Treasury |117

Substituting into the formula
USD 10,000,000 = L × 4.21236
USD 10,000,000/4.21236 = L
= USD 2,373,966
= USD 2,374,000, to the nearest USD 1,000
Annuity factor on the calculator
(1 – 1.06–5)/0.06
On the Casio FX 85 calculator, key in:
(1 – 1.06 [×□] – 5)) ÷ 0.06 =
This will display as:
(1–1.06^(–5)) ÷ 0.06
4.212363786

ANSWER 38

a) Net present value

The net present value (NPV) is the total present value of a series of related cash flows, treating
outflows as negative and inflows as positive.
A common example would be an initial investment outflow (negative) followed by series of
expected later net positive inflows from the investment.

Internal rate of return

Internal rate of return (IRR) is closely related to NPV.
IRR is the cost of capital that, if applied to discount each of a series of future cash flows,
together with any initial investment outflow, would result in an NPV of zero for the whole
series.
b) Both NPV analysis and IRR analysis provide a quick hurdle test to determine whether
investment proposals should be considered for further review, or rejected.
Proposals with negative NPVs should be rejected.
Similarly, proposals whose IRRs are lower than the appropriate hurdle rate should also be
rejected
When the hurdle rate is equal to the rate used to calculate the NPV, both IRR analysis and NPV
analysis will give the same recommendation.

ANSWER 39

Annuity factor
AFn,r = (1 – (1 + r)–n )/r
AF20,0.0425 = (1 – 1.0425–20)/0.0425 = 13.2944
Certificate in Treasury |118
Present value
PV = USD 1m × AF20,0.0425
= USD 13.2944m

ANSWER 40
Using the growing perpetuity factor:
GPF = 1/(r – g)
= 1/(0.06 – 0.02)
= 25
PV = EUR 1.5m × 25
= EUR 37.5m

Short calculation
1.5/(0.06 – 0.02)
= EUR 37.5m

ANSWER 41
EUR 78,571.

Workings
This is an example of a set of cash flows which should be divided up into smaller sets of cash
flows for valuation purposes.
The easiest way to value this is to split the cash flow into a T0 cash flow and a T1 to infinity
perpetuity.

First cash flow

The first flow of 5,000 is now, which is T0.

Growing perpetuity
The T1 cash flow, which is used in the growing perpetuity formula, will be
5,000 × (1 + 0.03)
= 5,150
The periodic cost of capital (r) = 0.10
g = 0.03
Valuing the cash flows from T1 to infinity using the growing perpetuity formula 1/(r – g), gives
5,150 × 1/(0.10 – 0.03)
= 73,571

Total present value

5,000 + 73,571 = 78,571.

Certificate in Treasury |119

ANSWER 42
a) Using the real rate formula:
real r = (1.10/1.03) –.1
= 0.0679612
= 6.79612%
As a sense check, the real rate of return is just less than 10% – 3% = 7%. It is slightly less than
the 7% because of compounding.
b) Real terms adjusted cash flow:
5,150 × 1.03–1
= 5,000
c) PV = Time 1 cash flow/r
= 5,000/0.0679612
= EUR 73,571.
The same answer is obtained by working in money terms:
5,150/(0.10 – 0.03) = 73,571

Certificate in Treasury |120

 STUDY SESSION
3
Foreign exchange market
fundamentals
CORE RESOURCES AND LEARNING OUTCOMES
These are the learning materials for this study session, with the relevant Unit 1 learning
outcomes that are addressed in the materials.
3.1 The foreign exchange market
LO10 Review the main features of, and participants in, the foreign exchange market in
order to understand how the market operates.
3.2 Foreign exchange market dealing conventions
LO11 Show how foreign exchange rates are calculated and used in order to meet the
needs of the organisation.
3.3 Forward foreign exchange markets
LO12 Explain the principles and practicalities of forward foreign exchange contracts and
short-dated foreign exchange swaps and how they can be used by the organisation
to protect itself against basic types of foreign exchange risk.
3.4 Linking spot rates, interest rates and forward rates
LO13 Evaluate the relationships between foreign exchange spot rates, forward rates, and
interest rates in related currencies, in order to identify any arbitrage opportunities
or mispricing in the rates quoted by market makers.
3.5 Study session 3 self-assessment exercises
Exercise questions that test the learning outcomes of this study session.

Study session 3 self-assessment online progress test: Don’t forget to try the multiple-
choice online quiz to assess your grasp of key concepts.

ENHANCE AND EXPAND

To access further material designed to enhance and expand what you have learned in
this study session, login to your course and look for this study session’s online resources.

Certificate in Treasury |121

 READING
3.1
The foreign exchange market
1 INTRODUCTION
The term ‘foreign exchange’ has two related meanings:

 a transaction for the exchange of one currency for another

 any currency other than the domestic currency.

Treasurers in all but the simplest businesses will have exposure to the management of foreign
currencies. A good understanding of the foreign exchange (FX) markets is fundamental for the
treasurer. There are several reasons why treasurers may be involved with the foreign
exchange market:
 to ensure that the right amounts of cash are in the right place at the right time and in the
right currency. Sales and purchases in foreign currencies have to be made so the relevant
currency must be sold or bought
 to arrange the funding of foreign subsidiaries whose domestic currency is different from
that of the parent. Surplus cash will also have to be extracted
 the market values of all currencies are subject to change, giving rise to foreign exchange
risks in relation to long-term funding of the organisation if money is raised in foreign
currencies.

To manage each of these tasks, treasurers need to exchange cash flows in currencies their
organisation doesn’t want for cash flows in currencies they do want. Treasurers will need to
understand how to use appropriate foreign exchange instruments to manage foreign currency
risk.
This reading introduces the foreign exchange markets and the context for corporate FX
transactions.

LO10 Review the main features of, and participants in, the foreign
exchange market in order to understand how the market operates.

2 THE FOREIGN EXCHANGE (FX) MARKET

The foreign exchange market is a global market-place in which banks, non-financial
corporations, governments and institutional investors trade currencies around the clock. It is
one of the largest and most extensive financial markets in the world. It is mostly an ‘over the
counter’ market, which means that deals are made directly between market participants as
opposed to deals being made on an exchange.

Certificate in Treasury |122

2.1 SIZE AND LOCATION
Key features of the FX markets include:

 substantial trading volumes resulting in a highly liquid market

 the high volumes, geographical dispersion and range of factors that can influence
movements in FX rates result in highly volatile prices
 due to the number of participants and size of the market, profit margins are very low on
any individual transaction
 it is increasingly technological and while the telephone is still used, most prices are posted
and deals struck using electronic media
 there is no physical market-place or exchange for foreign currency
 the foreign exchange markets are dominated by traders who take speculative positions –
effectively a bet on the strengthening or weakening of particular currencies. The traders
may work for a bank or for institutions such as hedge funds
 with trade becoming more global, there is an increasing business need to buy and sell
currencies in order to make foreign currency payments or to convert foreign currency
receipts. However, the volume of corporate hedging activity is comparatively small
 the foreign exchange markets facilitate movement of capital around the world.

Example 1: Turnover of OTC FX instruments

(BIS 2016)

2.2 PARTICIPANTS IN FOREIGN EXCHANGE RATE MARKETS

Participants in the FX markets include:

 banks dealing with each other, including commercial and investment banks
 non-financial corporates
 central banks
 pension funds
 insurance companies
 hedge funds
 individuals.

The bulk of FX deals are made by large commercial banks including Deutsche Bank, UBS and
Citibank. The banks facilitate the trading and investment activities of their corporate and
institutional clients by standing ready to lend or to exchange a wide range of currencies, and
in turn make markets in currencies amongst themselves. The vast majority of foreign
exchange transactions are traded in London. The next largest market is the USA.

Certificate in Treasury |123

2.3 DRIVERS OF FX TRANSACTIONS AND FX RATE MOVEMENTS
Traditionally, flows of money between currencies were largely determined by:

 import and export transactions

 institutional investors such as pension funds and insurance companies investing in
securities such as shares and bonds denominated in foreign currencies
 international corporations making direct investments in foreign subsidiaries, repatriating
funds or completing cross-border takeovers of foreign companies.

As currency restrictions were gradually lifted in the latter part of the twentieth century,
speculative currency trading, i.e. buying and selling currencies with the purpose of making a
profit from such transactions alone, began to assume increasing importance, and now
accounts for the majority of trading volume.
Speculative activity may drive FX rates away from the levels that supply and demand from
other sources might have determined. Currency speculators’ activities include trying to
predict the likely actions of central banks.

3 THE ROLE OF CENTRAL BANKS

In the major developed economies there is no official rate of exchange and the national
currency usually floats freely against other currencies. In this context, the central bank plays
two main roles:
 it supervises the market within its jurisdiction
 it maintains control over the supply of money and domestic interest rates which will
influence the attractiveness of the currency to foreign investors.

The central bank may seek to smooth out fluctuations in currency movements by buying and
selling currency in the markets, often working together with other central banks around the
world.
In countries that still have exchange controls, the central bank fixes the official rates of
exchange and may also act as the central counterparty in FX transactions.

4 TYPES OF MARKET PARTICIPANTS

Market participants include market makers, market takers and brokers.

4.1 MARKET MAKERS

Banks, which maintain a firm bid and offer price in a given currency pair by standing ready,
willing, and able to buy or sell at these quoted prices, are market makers.
Market makers display bid and offer prices for specific currency pairs.
Market makers are crucial for maintaining liquidity and market efficiency for the currencies
that they make markets in. The essential characteristic of a liquid market, i.e. a market in
which it is easy and cheap to transact, is that there are ready and willing buyers and sellers at
all times.

Certificate in Treasury |124

4.2 MARKET TAKERS
All other participants are market takers, also referred to as price takers. Market takers don’t
set prices, and they have to transact at the best price they can find amongst market makers.
Market takers may be:

 corporates
 non-bank financial institutions including hedge funds and asset managers
 market makers wishing to correct an unforeseen surplus or shortfall quickly
 smaller banks that are either not market makers or who need to trade currencies outside
their areas of specialist expertise.

4.3 BROKERS
Brokers act on behalf of clients, introducing currency buyers and sellers and taking a
commission for their services, i.e. brokerage. Brokers do not enter into deals in their own
right, i.e. as principals. Electronic dealing platforms, where available, have largely made
brokers obsolete in the FX market.

5 DEALING METHODS
5.1 BANKS AND CREDIT LINES
Corporates gain access to the FX market via their banks. A foreign exchange facility, or ‘line’,
is usually established with various credit limits. Without a line, the bank will in most cases not
trade.

5.2 TELEPHONE DEALING AND WEB-BASED PORTALS

Even if electronic dealing solutions are available, most corporates will maintain telephone
contact with their bank’s corporate dealing desk because most treasurers will wish to collect
intelligence on the market. The bank may also offer more favourable rates for certain
customers, or deal sizes not apparent on screen. However, most medium to large treasuries
will now transact most deals using web-based portals. These have the advantages that:
 there is almost no opportunity for misunderstanding or inappropriate deal pricing
 confirmation is immediate
 multi-bank portals give competitive pricing, i.e. quotes from more than one bank
 they facilitate straight-through processing.

5.3 DEALING ERRORS

Note that in dealing currencies, particularly by phone, it is very easy to get the transaction the
wrong way round and end up buying a currency that should have been sold. Every treasurer
has a story of this happening and so treasurers usually ensure that they rehearse their trades
before contacting their banks.

5.4 COMMITMENT AND CONFIRMATION

Regardless of the dealing system, once two parties have agreed terms (currency pair, who
buys which currency and who sells which currency, exchange rate and settlement date), both
are committed to the transaction, both by market convention and in major currency centres
by law (a trade is a trade). Hard copy or electronic confirmations are exchanged between the
parties to confirm their understanding of the deal (particularly important for phone-based
dealing, where voice recording of phone dealing is commonplace), preferably prior to
settlement.

Certificate in Treasury |125

5.5 SMALLER TRANSACTIONS
Despite automation, there is still an issue over how to transact very small transactions, say,
lower than USD 10-20,000. A US-based treasurer faced with paying a subscription for, say,
EUR 100 will not wish to use the interbank-based market to acquire such a small amount.
For this reason, some customers may buy or sell smaller amounts of foreign exchange in some
of the following additional ways:

Booking a rate
Booking a rate by written instruction to a bank, is where the FX rate is booked in advance of
a later payment instruction to which it must subsequently be matched. If the amount and date
of the subsequent transaction do not match, then penalties will be applied.

Immediate payments and receipts

Instructing an immediate payment, or accepting a receipt, of one currency from a bank
account denominated in another will give rise to an implied FX deal. However, the rate
attached to the deal will be set by the bank and will almost certainly be at an unattractive
rate.

Using credit or debit cards

Credit or debit cards can be used to make payments, e.g. travel expenses. The rates applied
by the card companies are likely to be poor, but the amounts are also likely to be small where
the money effect of the adverse exchange rate is not so great.

6 SUMMARY
In this reading you have looked at the main features of, and participants in, the foreign
exchange market, with the aim of understanding how the market operates. You have looked
at:
 key features of the foreign exchange rate market, including market size and market
location
 the role of central banks in the foreign exchange market
 the main market participants, including market makers such as banks, and market
takers such as corporates and brokers
 drivers of exchange rate transactions and movements
 dealing methods including via a bank, phone, web-based portals and the need for
credit lines, dealing errors, commitment and confirmation, smaller transactions

Certificate in Treasury |126

 READING
3.2
Foreign exchange market dealing
conventions
1 INTRODUCTION
In this reading we will look at some of the important conventions in the foreign exchange
market. These include currency codes, quotations (both spot and cross rates) and dealing
which are critical foundations for treasurers in fulfilling their responsibilities. This reading will
provide a range of worked examples to support your understanding and consolidate your
knowledge of the FX market.

LO11 Show how foreign exchange rates are calculated and used in order
to meet the needs of the organisation.

2 CURRENCY CODES
Each traded currency is identified by a standard code. Some examples are:
Australian dollar AUD Japanese yen JPY
Canadian dollar CAD Malaysian ringgit MYR
Chinese renminbi CNY New Zealand dollar NZD
Danish krone DKK Singaporean dollar SGD
Euro EUR Sterling GBP
Hong Kong dollar HKD Swiss franc CHF
Indian rupee INR US dollar USD
In general, the first two letters refer to the country and the third to the currency. For example,
GBP refers to Great Britain and the Pound.

3 HOW FOREIGN EXCHANGE RATES ARE QUOTED

A foreign exchange rate is quoted as one unit of fixed currency being equal to a variable
amount of another currency, for delivery on the value date.
All quotations are made up of two currencies:
 the ‘fixed currency’ or ‘base currency’, which is conventionally shown on the left
 the ‘variable currency’ or ‘terms currency’, which is conventionally shown on the right.

Certificate in Treasury |127

A foreign exchange (FX) quotation shows one unit of the fixed or ‘base’ currency to be
exchanged for a number of units of the variable currency.

EXAMPLE 1: Spot quote USD/AUD

What does the USD/AUD foreign exchange rate of 1.2706 mean?

Solution
The currency on the left, the US dollar, is the fixed ‘base’ currency.
AUD is the ‘variable’ currency.
Therefore, USD/AUD 1.2706 means that USD 1 would be exchanged for 1.2706 AUD.

4 BUYING AND SELLING FOREIGN CURRENCIES

When dealing, a market maker (normally a bank) will quote two prices:

 a price for buying the base currency (the bid price) and
 a price for selling the base currency (the ask price or offer price).

Bid price Offer price

USD/AUD 1.2704 1.2709
Market maker (bank) buys the Market maker (bank) sells the
base currency base currency
Market taker (customer) sells the Market taker (customer) buys the
base currency base currency
Market maker (bank) sells the Market maker (bank) buys the
variable currency variable currency
Market taker (customer) buys Market taker (customer) sells the
the variable currency variable currency
The bank and the customer are on opposite sides of a transaction. If the bank sells a currency
then the customer buys that currency. For example, if a bank buys AUD and sells USD, the
customer must be selling AUD and buying USD. The bank is the price maker and the corporate
customer is the price taker.

4.1 WHICH SIDE OF THE QUOTE?

A useful general rule to determine which side of the quote to take is that the market makers
must always get the better side of the quote. The market makers need a profit on each
transaction, to pay the necessary expenses of making a market quote.
Gets Gives
Market maker More Less
Market taker Less More
Let’s assume the market maker is a bank, and the market taker is not a bank.

Certificate in Treasury |128

For example, given:
USD 1 = 1.2704-1.2709 AUD
The bank will:
 buy USD for fewer AUD, 1.2704 per USD bought
 sell USD for more AUD, 1.2709 per USD sold.

EXAMPLE 2: Buying currency

Say USD/BGN (Bulgarian Lev) is quoted by the bank at 1.7920-1.7930 (this type of quote is a
two-way price). The base currency is the US dollar, because it is set first in the currency pair.
So the bank’s two-way prices are to:

 buy USD 1.00 and sell BGN 1.7920 and to

 sell USD 1.00 and buy BGN 1.7930.

And, a customer can:

 sell USD 1.00 and buy BGN 1.7920 and
 buy USD 1.00 and sell BGN 1.7930.

We can generalise the above result: the bank always ‘buys the base’ at the bid (lower) rate
(‘low’) and ‘sells the base’ at the higher rate (‘high’).
In other words, the bank will deal at the rate that is more favourable to itself.
The guiding rule is that the bank customer will always receive the least amount for the
currency when selling and pay the highest amount when buying.

4.2 ABBREVIATED FX QUOTATIONS

Rates are often quoted in a more abbreviated fashion, rather than being spelled out in full.
For example:
USD/AUD 1.2704-09
Spelled out in full, this quotation is:
USD 1 = 1.2704-1.2709 AUD
This means that USD 1 would be exchanged either for AUD 1.2074, or AUD 1.2709, depending
on whether the customer was:
 buying or selling
 USD or AUD.

The first full number refers to the bid price (what the customer will obtain in AUD when selling
USD to the bank), and in this case includes four digits after the decimal point.
The second component (after the dash) is used to obtain the offer price (what the customer
has to pay in AUD if buying USD from the bank). The offer price is obtained by increasing the
first component until the last two digits are equal to the digits in the second component. In
this example, the bid price of 1.2704 is increased until the final 2 digits are 09 – giving an offer
price of 1.2709.

Certificate in Treasury |129

As another example:
GBP/NZD 1.8498 - 03
This refers to a bid price of 1.8498. To get to the offer price, the bid price must be increased
until the last 2 digits are 03 – giving an offer price of 1.8503.
In the spot quote, the offer price will always be larger than the bid price.

5 SPOT TRANSACTIONS INCLUDING IDENTIFYING THE SPOT DATE

A spot transaction is a FX transaction made now (the deal or trade date) for settlement on the
spot date (the value date or maturity date, which is the date at which the funds become usable
to the beneficiary).
The exchange rate applied is known as the spot rate. The details of the trade – the currencies
exchanged, who buys and sells which currency, amounts, exchange rate, payments
information – are agreed by the counterparties on the deal date and the two currencies are
exchanged on the spot date.
The general definition of the spot date is the second working day following the deal date, i.e.
deal on day T, settle on day T+2. The exception is for USD/CAD, where the spot date is the day
following the deal date, i.e. deal on day T, settle on day T+1.
Alternatively, a forward transaction is for settlement at an agreed date later than the spot
date and same day or tom/next (tomorrow/next working day) is for settlement in advance of
spot.
The advent of the Euro combined with improved electronic payment and deal confirmation
capability for both corporates and banks has led to an increase in the volume of same day and
tom/next value transactions.
The spot rate (price) in freely floating currencies is a result of supply and demand.

Identifying the spot date

The spot date is typically two working days after the spot transaction is agreed. If today, the
trade date, is day T, the next working day is T+1, and the second working day is T+2. However,
the definition of the ‘second working day’ calls for some care.
In order for a deal to be completed, the dealing centres for both currencies involved in the
exchange must be open on the spot date. If either is closed, the spot value date moves forward
to the next working day when both centres are open.
If the T+1 date is a holiday in the non-US currency-dealing centre, then this causes the deal to
roll forward one day. If the T+1 date is a holiday in the USA, but not in the non-US currency-
dealing centre, the settlement date is not affected by this rule.
EUR settlement depends on holidays in the country where settlement takes place.
Due to these complexities, dealing and value dates for all material or unusual FX deals should
be confirmed with counterparties well in advance.

Certificate in Treasury |130

6 CALCULATING SPOT CROSS RATES
Traditionally, most currencies are quoted against the USD, and the majority of transactions
still involve USD as one of the traded currencies, although increasingly currencies are also
being quoted against the Euro. If a customer wants to exchange two currencies, which are not
quoted against each other, then a ‘cross-currency deal’ must be entered into.
Most cross-currency deals involve two USD deals for the bank. For example, a transaction to
sell GBP in exchange for Singapore dollars (SGD) would involve the bank in two transactions,
one to sell GBP in exchange for USD and the second to sell USD in exchange for SGD.
The two transactions would be carried out by the bank behind the scenes. It would, however,
offer a single price for the cross-currency deal to the customer. The corporate selling GBP in
exchange for SGD from the bank sees and executes only one deal.
Cross rates are worked out by notionally buying and then selling the more widely traded
intermediate currency, usually the USD. For example, the AUD/HKD cross rate will be
calculated from the quotes for USD/HKD and USD/AUD.

Rates used
The rates used in each notional leg are the usual buying and selling rates, as if the intermediary
currency, e.g. the USD, had been actually bought and sold.
So the cross-rate quote implied by the combination of the two related FX rates always
increases the bid-offer spread to reflect the additional notional transactions to buy and sell,
e.g. USD.

Guideline for combining quotes

Here we use the following guideline to achieve the correct combinations:
Is the intermediate currency, e.g. USD, quoted ‘on the same side’ or ‘on different sides’ in the
two quotes? That is, is it the base currency in both or the base in the first quote and the
variable currency in the second?
For example, in the currency pairs USD/AUD and USD/BGN the USD is quoted on the same
side in each quote; it is the base currency in each.
SAME SIDE CROSS DIVIDE
‘Same side, cross divide’ means if the currencies are quoted with USD on the same side, cross
divide the two quotations. This will increase the bid-offer spread.
For example
Suppose the following rules are quoted in the market:
USD/AUD 1.4580 – 1.4590
USD/BGN 1.7920 – 1.7930
The AUD/BGN two-way rate is (cross dividing):
1.7920/1.4590 = 1.2282
1.7930/1.4580 = 1.2298

Certificate in Treasury |131

AUD 1 = 1.2282-1.2298 BGN
(Increasing the bid-offer spread)
This is exactly the same result as would be obtained from physically dealing in the USD against
each of BGN and AUD in turn (to within the accuracy of the cross quote decimals).

EXAMPLE 3: CHF/HKD cross rates

Identify the following rates in the market:
USD/HKD 6.0750-60
USD/AUD 1.7920-30
Calculate the AUD/HKD cross rates (both bid and offer).
Solution
USD is quoted on the same side in each currency pair.
So we will divide the quotes:
We cross divide the quotes in order to increase the spread; this ensures that we obtain the
highest and lowest cross rate quote in each case.
USD/HKD 6.0750 6.0760
USD/AUD ÷ 1.7930 ÷ 1.7920
AUD/HKD = 3.3882 = 3.3906

1 AUD = HKD 3.3882-3.3906 (24 points spread looks wider, OK)

DIFFERENT SIDES MULTIPLY SAME SIDE
‘Different sides, multiply same side’ means if the currencies are quoted with for example USD
on different sides, multiply the same side of the two quotations.
This will also increase the bid-offer spread.

EXAMPLE 4: GBP/CHF cross rates

You are given the following quotes:
KYD/USD 1.6230-40 (KYD = the Caymanian Dollar)
USD/BAM 1.7920-30 (BAM = the Bosnian Marka)
Calculate the KYD/BAM cross rates.
Solution
USD is quoted on different sides in each currency pair.
So we will multiply the quotes together:
KYD/USD x USD x BAM = GBD/CHF

Certificate in Treasury |132

We multiply the same side of the two quotes in order to increase the spread:
KYD/USD 1.6230 1.6240
Multiplied by × 1.7920 × 1.7930 (normal
USD/BAM USD/BAM quote,
smaller number
first)
= KYD/BAM = 2.9084 = 2.9118
1 KYD = BAM 2.9084-2.9118 (34 points spread looks wider, OK)

7 SUMMARY
In this reading, you have studied how foreign exchange rates are calculated and used in order
to meet the needs of the organisation. You have looked at:
 currency codes
 how foreign exchange rates are quoted
 buying and selling foreign exchange
 spot transactions
 calculating cross rates

ENHANCE YOUR UNDERSTANDING

Now that you have completed this reading, review the podcast and webinar to enhance your
understanding. The podcast and webinar are accessible from your course page.

Certificate in Treasury |133

 READING
3.3
Forward foreign exchange markets
1 INTRODUCTION
Most transactions in the foreign exchange (FX) market are entered into for more or less
immediate delivery (spot). However, the FX market is flexible enough to enable transactions
to be entered into today, to settle on any practicable future date. This flexibility makes the FX
market useful for cash and liquidity, and foreign exchange risk, management, as it enables the
treasurer to alter not only the currency but also the timing of cash flows. This gives some
important benefits:
 cash flows can be managed to match the profile needed to support the trading cash flows
of the business
 surpluses or shortfalls in one currency can be switched to another, so spare cash in one
currency can be used to fund a shortfall in another
 the domestic currency equivalent of a future payment or receipt in foreign currency can
be effectively fixed in advance.

LO12 Explain the principles and practicalities of forward foreign exchange

contracts and short-dated foreign exchange swaps and how they can be
used by the organisation to protect itself against basic types of foreign
exchange risk.

2 DIFFERENCES BETWEEN SPOT AND FORWARD FOREIGN EXCHANGE

RATES
2.1 SPOT FX RATES
A spot transaction is an FX transaction entered into now (the deal or trade date) for settlement
on the spot date (the value date or maturity date). The spot date is usually two business days
after the deal date although there are some complicated rules to allow for public holidays.
Spot is the default maturity for a foreign exchange contract.
The exchange rate applied is known as the spot rate.

2.2 FORWARD FX RATES

The difference between a spot and a forward contract is that the settlement date is at a date
later than the spot date.
Today’s forward rate derives from the spot rate plus interest rate differentials.

Certificate in Treasury |134

2.3 FOREIGN EXCHANGE RISK MANAGEMENT
Organisations transacting in foreign currencies are exposed to two basic types of foreign
exchange (FX) risk, relating to FX payments and to FX receipts:

 for FX payments, if the foreign currency strengthens, the domestic currency equivalent
will become more expensive
 for FX receipts, if the foreign currency weakens, the domestic currency equivalent will
become less valuable.

The organisation can protect itself against both of these types of foreign exchange risk by
using appropriate forward foreign exchange contracts.

3 VALUE DATES FOR FORWARD EXCHANGE

CONTRACTS
The foreign exchange market quotes forward rates for dates at standard intervals (daily,
weekly and 1, 2, 3, 6 and 12 months) from the spot date.
A ‘long-dated forward market’ exists for actively-traded currencies of up to five years or more,
but this is a very specialised market.

3.1 CALCULATION FROM THE SPOT FX DATE

All forward dates are calculated from the spot FX date. For example, the 1-month forward
date is calculated by taking the spot date, and the numerically equivalent date in the next
month. If this is a non-working day in either centre, then the related forward date moves on
to the next working day.

3.2 THE ‘END END’ RULE

The exception is the ‘end end’ rule. This states that if the current spot date is the last working
day of this month, then the one month, two month etc. date will be the last working day of
the relevant month. So if a deal is struck on 28 June with a spot date of 30 June, the one month
date will be the last business day in July.

3.3 BROKEN DATES

Customers can however request any date for settlement to suit their own requirements and
a date which does not fall as exact weeks or months is called a ‘broken date’. The rates
obtainable by corporate customers for such broken dates will be slightly less favourable than
the rates for standard settlement dates but generally not sufficiently so to merit trading for
standard settlement dates with the resultant loss of hedge effectiveness.

4 FORWARD FOREIGN EXCHANGE RATE QUOTING CONVENTIONS

Outright forward rates are constructed from two elements:
 the spot FX rate
 an adjustment known as ‘forward points’.

The forward points are sometimes also known as ‘swap points’ – or ‘pips’ (price interest
pointers).
There are two ways of obtaining a quotation for an outright forward deal:

Certificate in Treasury |135

Method 1: An outright price; the corporate asks the bank to quote a single forward price
consisting of the sum of the spot and the forward points. Less active treasuries and smaller
companies often prefer this method, which is both simple and clear. Method 1 is also well
suited to quoting ‘same day’ or ‘tom’ deals where the points’ adjustment is small. Same day
and tom deals are those which settle before the spot date. Their pricing is adjusted in exactly
the same way as forward deals, but the adjustment is smaller of course, reflecting a shorter
time before settlement.
Method 2: Separate spot rate and forward points; effectively asking for a spot deal and a swap.
Many corporate dealers prefer Method 2 as it has the following advantages:
 it reflects the way that the bank constructs an outright forward rate
 it is more transparent – both elements can be quoted competitively and compared to
screen rates
 as spot prices tend to be more volatile than the forward points in a moving market some
treasurers prefer to lock in the spot rate first
 alternatively, as forward points tend to be driven by individual banks’ appetite for funds
and thus may vary, whereas the spot market is almost perfect, the points can be
requested first to identify how much better one or other bank’s spot price must be to win
the deal.

The two elements, i.e. spot rate and forward points, can be separated and dealt with by
different counterparty banks if the difference in prices warrants such an approach.
Method 2 quotes will look like the table in Example 1, which shows the spot FX rate and the
forward points, or pips, for the relevant forward dates. The points are either added to, or
subtracted from, the spot rate to derive the forward rate.
‘Price’ is a generic term to describe the cost or rate of a transaction. In the spot FX markets
‘price’ is the spot exchange rate; in the forward market ‘price’ is expressed in terms of forward
points. The forward points are usually quoted to the same level of precision, but the
associated decimal point is not displayed.

EXAMPLE 1: Calculating forward rates

Using the rates below, consider:
a) 1-month USD/SEK
Spot 9.0750 9.0760
Points + 0.0060 + 0.0080 Points ascending, add
Forward 9.0810 9.0840
In summary:
 base currency is more expensive in the forward market (trading at a premium)
 right-hand forward points are higher (points ascending)
 add the forward points.

Certificate in Treasury |136

b) 1-month USD/AUD
Spot 1.3920 1.3930
Points (0.0028) (0.0025) Points descending,
deduct
Forward 1.3892 1.3905
In summary:
 base currency is cheaper in the forward market (trading at a discount)
 right-hand forward points are lower (points descending)
 deduct the forward points.

Notice applying the forward points always makes the forward bid-offer spread wider than the
spot spread.
This happens both when ascending forward points are added, and when descending points
are deducted.

5 FORWARD FX RATES
Market makers such as banks quote two prices: a price for the bank to buy the base currency
(bid price) and a price for the bank to sell the base currency (the ask price or offer price). The
difference between the bid and the offer is known as the spread, or the bid-offer spread, and
this is how the bank makes its profit on the deal.
Bid-offer spreads are wider for forward contracts than for spot deals.
Spot and forward quotes are conventionally expressed in the format:
USD/BAM 1.7920-30.
The base or fixed currency is the US dollar, because it is set first in the currency pair. The
second currency in the pair is the terms or variable currency.
The bank buys the base low and sells the base high.
Exchange rates are always quoted per 1 unit of base currency.
So the bank’s prices are to:

 buy USD 1.00 and sell BAM 1.7920 and to

 sell USD 1.00 and buy BAM 1.7930
 the bank’s spread is BAM 0.0010 per USD.

5.1 AT A PREMIUM OR AT A DISCOUNT

In the forward FX market, if the base currency is more expensive for forward delivery than
spot, it is said to be at a premium. If the base currency is cheaper forward than spot, then it is
said to be at a discount.
Whether a forward rate is at a premium or at a discount is determined by the interest rate
differentials between the currencies and can be ascertained by looking at the forward points.

Certificate in Treasury |137

5.2 ADJUSTING FOR FORWARD POINTS
For each forward date two figures are quoted for the points – one on the left, and one on the
right. If the right-hand points are higher than the left-hand points the points are ‘ascending’:
ascending points are added to the spot rate to give the forward rate, and so the base currency
is at a premium in the forward market.
Look at the USD/SEK rates in Example 2. Notice that for each forward month, the right hand
points are higher than the left-hand points, e.g. 430-460 for six months forward. The points
are ascending.
Ascending points are added to the spot rate.
This indicates that the base currency (USD) is quoted forward at a premium to the variable
currency in the forward market.
Now look at the GBP/USD rates in Example 2. Notice that for each forward month, the right-
hand points are lower than the left hand points, e.g. 48-45 for one-month forward. The points
are descending.
Descending points are deducted from the spot rate.
This indicates that the base currency (GBP) is quoted forward at a discount (to the USD) in the
forward market. With the GBP/USD spot rate at 1.6230-1.6240 and the 3-month points at
140–135, the 3-month forward rate is 1.6090-1.6105, i.e. 1.6230 minus 0.0140 and 1.6240
minus 0.0135.
Notice that the spread for forward dates is always greater than the spread for the spot date.

EXAMPLE 2: Spot FX rate and the forward points quotes

The table shows quotes for the spot FX rate and the forward points.
Spot 1-mth 3-mth 6-mth 1-year
GBP/USD 1.2230-40 48-45 140-135 271-264 502-492
USD/CHF 0.9920-30 28-25 77-72 150-143 322-312
USD/SEK 9.0750-60 60-80 210-230 430-460 750-825
For example, the 3-month USD/CHF rate would be 0.9920 adjusted by 0.0077 or 0.9930
adjusted by 0.0072.

6 FORWARD FOREIGN EXCHANGE CROSS RATES

Forward rates involving cross currencies are calculated in a similar way to spot cross currency
rates.
Consider the spot FX rates and forward points in Figure 1.

Certificate in Treasury |138

Figure 1: USD/CHF and USD/AUD rates

The forward points are descending for both currency pairs, for all maturities.

Customer 1 selling AUD for CHF for value 3 months forward

If a customer wanted to sell AUD 2m in exchange for CHF, the price would be worked out via
the respective forward rates for USD/AUD and for USD/CHF, and notionally exchanging USD.
For the customer selling AUD 2m for CHF:
The customer would notionally sell AUD 2m and buy USD 1,119,946.24 at a rate of 1.7930-
0.0072 = 1.7858 (points descending, deduct).
The customer would notionally sell their USD 1,119,946.24 for CHF at the less favourable
USD/CHF rate.
This is 1 USD = CHF (1.4580-0.0140) = 1.444 (points descending, deduct).
The amount of CHF received in exchange for AUD 2m is:
1,119,946.24 × 1.4440 = CHF 1,617,202.
This is the same result as would be obtained from physically dealing in the USD against each
of AUD and CHF in turn.

Customer 2 buying AUD for CHF for value six months forward
A second customer wishing to buy AUD 2,000,000 for CHF would also deal notionally in each
of USD/AUD and USD/CHF, on the worse side of each quote.
The CHF paid by this customer would be:
USD notionally paid for buying AUD 2m:
= 2,000,000/(1.7920-0.0148) (points descending, deduct)
= 2,000,000/1.7772
= USD 1,125,365.74
CHF paid for notional purchase of USD 1,125,365.74:
= 1,125,365.74 × (1.4590-0.0264) (points descending, deduct)
= 1,125,365.74 × 1.4326
= CHF 1,612,199.

Certificate in Treasury |139

7 FOREIGN EXCHANGE SWAPS PRINCIPLES
A foreign exchange swap (FX swap) is a composite contract consisting of two exchanges (legs).
The contract is for the exchange of one currency for another on a near date (commonly spot)
combined with a reverse exchange of the same two currencies at a later date.
For example, if a company has a shortfall of EUR and a surplus of GBP for a week, it could
enter into the following FX swap contract:

 to swap EUR for GBP for value spot (the ‘near leg’)
 simultaneously agree to exchange EUR for GBP for value a week later (the ‘far leg’).

FX swap contracts may also be used to adjust (roll) an outright forward FX contract to a later
date.

EXAMPLE 3: FX swap contract used to roll over an outright FX deal

You have entered into an outright forward FX deal to sell USD for GBP, expecting to receive
USD from a customer on 23 September.
Note that there is only one exchange, making this an outright forward FX deal.
Original outright forward trade:
For value 23 September
Pay USD
Receive GBP
Now you discover that the transaction must be delayed as the funds will not be received until
30 September. You can use an FX swap to roll over (or ‘unwind’) the original trade and re-
establish the exchange for value one week later.

FX swap to ‘roll’ original trade forward

Near leg Far leg
This unwinds the original trade Re-establishes the original trade on a new (later) date
For value 23 September For value 30 September
Receive USD Pay USD
Pay GBP Receive GBP
The trade whose original maturity was 23 September has now been re-established with
maturity 30 September.

8 FOREIGN EXCHANGE SWAPS CALCULATIONS

Remember that FX swaps are priced by reference to the far leg and therefore the ‘cost’ of the
FX swap will be the forward points applicable to the far leg of the transaction.
Consider the following spot rates and forward points:

Certificate in Treasury |140

 Spot 1-mth 3-mth 6-mth 1-year
USD/DKK 8.0750-60 60-80 210-230 430-460 750-825
The far leg points are calculated in the same manner for an FX swap as for an outright forward
FX deal. In this case the 1-month outright forward USD/DKK exchange rates are:
Spot 8.0750 8.0760
Forward points + 0.0060 + 0.0080 Points ascending, add
Forward rate 8.0810 8.0840
Let us assume that the swap under consideration consists of the corporate paying DKK in the
near leg, and receiving DKK back in one month’s time (the far leg).
In the far leg, the bank buys base (USD) from the customer and sells the customer DKK so the
transaction is on the bid side (LHS), and the forward points to be applied are therefore +
0.0060.
The difference between the near leg rate and the far leg rate will be +0.0060.
In theory, the near leg rate can be any rate within the spot FX bid-offer spread but market
practice is to use the spot rate that would apply to the forward transaction to avoid any
confusion.
In this case, the far leg for re-exchange would be 8.0750 + 0.0060 = 8.0810 DKK.
The transaction for the customer would be:
 near leg: Pay DKK, receive USD, at USD1 = 8.0750 DKK
 far leg: Receive DKK, pay USD, at USD1 = 8.0810 DKK.

9 SUMMARY
In this reading, you have examined the principles and practicalities of forward foreign
exchange contracts and short-dated foreign exchange swaps and how they can be used by the
organisation to protect itself against basic types of foreign exchange risk.
You have looked at:
 the differences between spot and forward exchange rates
 value dates for forward exchange contracts
 forward foreign exchange rate quotations
 forward foreign exchange rates achieved
 forward foreign exchange cross rates
 foreign exchange swaps principles
 how to undertake calculations in relation to foreign exchange swaps.

Certificate in Treasury |141

ENHANCE YOUR UNDERSTANDING
Now that you have completed this reading, review the webinars to enhance your
understanding. The webinars are accessible from your course page.

Certificate in Treasury |142

 READING
3.4
Linking spot rates, interest rates and
forward rates
1 INTRODUCTION
Forward foreign exchange (FX) rates are derived from spot foreign exchange rates and the
interest rates applicable to the currency pair being quoted. This reading looks at the links
between spot and forward rates and how arbitrage links the interest, spot and forward rates.
Forward FX rates differ from spot rates because of the time value of money, i.e. cash
receivable or payable today is worth more than the same cash receivable or payable in the
future. The difference in value is due to interest rates, and the effects of adjustment of interest
rates when calculating the forward rate between two currencies. Interest rates in each
currency are established by the international (Eurocurrency) markets for borrowing and
lending currencies.
Note that the spot exchange rate on the maturity date will be different from what the forward
exchange rate is today. The future spot rate will reflect the economic circumstances on that
date, which in turn will be affected by uncertain future events, and by economic data not
known today.
The forward price derives from the spot rate plus interest rate differentials, and not directly
from market expectations. Within stable markets, the forward rate is theoretically an
unbiased predictor of the future spot rate (as suggested by ‘expectations theory’) although
there is question as to how often markets are ‘stable’.

LO13 Evaluate the relationships between foreign exchange spot rates,

forward rates, and interest rates in related currencies, in order to identify
any arbitrage opportunities or mispricing in the rates quoted by market
makers.

2 INTEREST RATE PARITY AND IMPLIED FORWARD RATES

Interest rate parity theory links four traded market rates:

 spot FX rate
 forward FX rate
 interest rate in the first currency
 interest rate in the second currency.

If any three of these rates is known, the fourth rate can be calculated.

Certificate in Treasury |143

2.1 INTEREST RATE PARITY FORMULA
Under efficient market conditions interest rate parity predicts the forward FX rate (available
in the market today) should be equal to the spot FX rate, adjusted for the difference in interest
rates between the currency pair over the relevant period.
For example currencies A and B quoted as a variable amount of currency A, to one unit of
currency B.
1  rA
  Spot (B/A)  Forward (B/A)
1  rB
Where:
Spot (B/A) = the spot FX rate (one unit of B to a variable number of A)
rA = periodic interest rate for A
rB = periodic interest rate for B

2.2 INTEREST RATE PARITY IN PRACTICE

This generally holds because otherwise an investor could borrow currency at an agreed fixed
interest rate, exchange it at the spot FX rate and invest the proceeds at an agreed fixed rate
to be re-exchanged on maturity at a contracted forward FX rate, and so make an arbitrage
profit.
This is called ‘covered interest arbitrage’, and makes the forward FX rate, spot FX rate and
related currency interest rates move rapidly towards equilibrium.
The ‘no arbitrage’ assumption in interest parity theory predicts e.g. if we borrow cheaply in
one currency, and lend at a higher interest rate in another currency – and hedge forward the
related foreign exchange exposure – then our foreign exchange loss will exactly balance and
eliminate our gain on the interest rate differential.
In practice, arbitrage opportunities do arise, although they tend to be small and short-lived.
The activities of arbitrageurs in the market cause the related rates to re-converge to the ‘no
arbitrage’ relationship.

2.3 IMPLIED FORWARD FX RATES

Example 1: Implied forward rate

Calculate the expected 6-month (181-day) forward FX rate if the current spot FX rate is
USD/CHF 1.0227, and 6-month interest rates are 3% in USD and 2% in CHF.

Solution
1  rCHF
  Spot (USD/CHF)  Forward (USD/CHF)
1  rUSD

Where:
spot (USD/CHF) is USD 1 to a variable number of CHF
rCHF = periodic interest rate for CHF = 0.02 × 181/360 = 0.0100556
rUSD = periodic interest rate for USD = 0.03 × 181/360 = 0.0150833

Certificate in Treasury |144

USD is the higher interest rate currency, so it is weaker in the forward FX market, compared
with spot, as follows:
(1.0100556/1.0150833) × 1.0227
= USD 1 = 1.0176 CHF
The number of CHF which would be exchanged for USD 1 is fewer in the forward FX market.
USD is weaker (it only buys CHF 1.0176 compared to spot of CHF 1.0227) in the forward FX
market, as expected as the currency with the lower rate (CHF) will trade at a premium in the
forward market.

3 THE EUROCURRENCY MARKET AND ITS ROLE IN SETTING FORWARD FX

RATES
The forward FX markets are driven by the interest rates established in the Eurocurrency
market. This is the international market where participants borrow and deposit currencies
outside their country of origin. For instance, USD borrowed in Japan would form part of the
Eurocurrency market (since the USD is not the currency of Japan). Notice that Eurocurrency
markets need not be in EUR, or have anything to do with Europe.
Interest rates differ between currencies and lending/deposit periods. Example 1 shows
interest rates for two main currencies. As in the FX market, bid and offer rates are quoted,
although unlike the FX markets, the bid rate is not always quoted first.
From Figure 1 you can see that:
Six-month USD
Bank (Market maker) Customer (Market taker)
Bid Deposit 1.15625 %
Offer Borrow 1.18750 %
A market maker has the benefit of the spread, i.e. the difference between the bid and the
offer quotes, whereas a market taker (the situation of a corporate customer) suffers the cost
of the spread.

Figure 1: Bid and offer quotes on trading screens

Certificate in Treasury |145

These rates are referred to as interbank rates, as they are the interest rates at which first-class
banks will deal with each other.
Strong corporate customers borrowing funds will pay a little more than the interbank
borrowing (offered) rate, i.e. a margin above the interbank offered rate, but should be able to
deposit funds at close to the bid rate.

4 ARBITRAGING BETWEEN THE SPOT FX RATE, INTEREST RATES AND THE

FORWARD FX RATE
When the forward FX rate differs from the figure predicted by interest rate parity, there may
be an arbitrage opportunity to borrow a cheaper combination of market deals, and lend a
more expensive one.

EXAMPLE 2: Arbitraging between the spot FX rate, interest rates and -forward FX rate
You can deal today at the following rates in the market.
Spot FX rate USD/CHF 1.0227
6-month (181-day) interest rates:
3.0000% in USD
2.0000% in CHF
Forward FX rate USD/CHF 1.0200
a) Identify the arbitrage opportunity between these rates.
b) Calculate the potential arbitrage gain, assuming an initial amount of USD 1,000,000
or its equivalent in CHF.

Solution
a) Theoretical forward FX rate, calculated from the interest rates:
1  rCHF
  Spot (USD/CHF)  Forward (USD/CHF)
1  rUSD

rCHF = periodic interest rate for CHF = 0.02 × 181/360 = 0.0100556

rUSD = periodic interest rate for USD = 0.03 × 181/360 = 0.0150833
(1.0100556/1.0150833) × 1.0227
= USD 1 = 1.0176 CHF
This is different from the prevailing market forward FX rate of USD 1 = 1.0200 CHF.
USD are stronger in the forward market than the interest rate differential implies.
Therefore the opportunity is to hold USD in 181 days’ time by:
Borrowing CHF, exchanging them for USD, depositing the USD, and striking a forward FX
contract to sell the USD forward at a favourable rate.

Certificate in Treasury |146

b) Borrowing USD 1,000,000 equivalent of CHF:
= 1,000,000 × 1.0227
= CHF 1,022,700
CHF repayable at maturity:
= 1,022,700 × (1 + (0.02 × 181/360))
= CHF 1,032,984
USD receivable from maturing deposit:
= 1,000,000 × (1 + (0.03 × 181/360))
= USD 1,015,083.33
These will be exchanged at the pre-agreed market forward rate for:
1,015,083.33 × 1.0200
= CHF 1,035,385
This exceeds the CHF 1,032,984 needed to repay the CHF borrowing.
The arbitrage gain enjoyed at maturity is:
1,035,385 – 1,032,984
= CHF 2,401

5 LINKING INTEREST RATES TO FX TRANSACTIONS, INCLUDING THE USE

OF MONEY MARKET HEDGES
Corporate market pricing is based on interbank rates, plus a spread (or margin, i.e. the
additional cost of borrowing compared to the interbank rate).
This corporate spread will impact on which market a corporate should transact in.
Using the money markets and spot and forward markets to obtain the best available interest
rate is known as money market hedging.

EXAMPLE 3: A money market hedge

Your organisation needs to borrow EUR 50m for 182 days.
You have been quoted a rate of 4.00% to borrow EUR.
Alternatively you could borrow USD at a rate of 3.00% and swap the proceeds for EUR.
USD/EUR is currently trading at a rate of 0.6300, and you have been quoted forward points of
+ 25.
a) Why might you investigate the USD borrowing in these circumstances?
b) Which method of obtaining the EUR required is cheaper, and by how much?

Certificate in Treasury |147

Solution
a) In simple terms, it might turn out to be cheaper to borrow via the USD route rather than
directly in EUR. All other things being equal, it would normally be preferential to use the most
cost-effective source of funding.
b) You will compare the cost of:

 direct borrowing in EUR

 a swapped USD borrowing.

i) Direct borrowing in EUR

Direct EUR borrowing for 182 days.
Interest = EUR 50,000,000 × 0.04 × 182/360
= EUR 1,011,111
Total repayable = EUR 51,011,111

ii) Swapped USD borrowing

Steps:
a) Amount of USD to borrow
b) USD repayable
c) EUR repayable
a) Amount of USD to borrow.
We need EUR 50m and the spot FX rate is USD = 0.6300 EUR
We will borrow:
50,000,000/0.6300
= USD 79,365,079.37
b) Calculate USD repayable
We will repay USD of:
79,365,079.37 × (1 + (0.03 × 182/360))
= USD 80,568,783
c) Calculate EUR repayable
The forward FX rate is:
0.6300 + 0.0025
USD 1 = 0.6325 EUR
EUR repayable
80,568,783 × 0.6325
= EUR 50,959,755
This appears to be cheaper than the direct borrowing in EUR.

Certificate in Treasury |148

The potential saving from using the swapped USD borrowing is:
51,011,111 – 50,959,755
= EUR 51,356

6 SUMMARY
In this reading you have looked at the relationships between foreign exchange spot rates,
forward rates, and interest rates in related currencies, in order to identify any arbitrage
opportunities or mispricing in the rates quoted by market makers. In particular, you have
examined:
 interest rate parity and implied forward rates
 the Eurocurrency market and its role in setting forward foreign exchange rate
 arbitraging between the spot FX rate, interest rates and the forward FX rate
 linking interest rates to FX transactions, including the use of money market hedges.

ENHANCE YOUR UNDERSTANDING

Now that you have completed this reading, review the podcast and webinar to enhance your
understanding. The podcast and webinar are accessible from your course page.

Certificate in Treasury |149

 SELF-ASSESSMENT
3.5
Study session 3 exercises
Use these exercise questions to assess your understanding of the learning outcomes of
this study session.

You should also try this study session’s online progress test which is a short multiple-
choice test designed to assess your grasp of key concepts.

QUESTIONS
QUESTION 1
LO10
You are an assistant group treasurer. For the benefit of a new team member, outline the key
features of foreign exchange markets.

QUESTION 2
LO10
You work in the treasury department of a large corporate. Explain to a colleague the benefits
of using both telephone dealing and web-based portals in your foreign exchange transactions.

QUESTION 3
LO10
A group of students who are studying finance are visiting your company. Prepare a short
briefing on the role of the central bank in countries where there is no official rate of foreign
exchange.

QUESTION 4
LO11
For a non-financial board director, explain the key difference between a forward foreign
exchange deal and a spot foreign exchange deal.

QUESTION 5
LO11
The following foreign exchange (FX) rates are quoted in the market.
USD/EUR 0.6325-0.6335
USD/NOK 4.9839-4.9849
NOK stands for Norwegian Krone.
What are the proceeds or costs for each of the following customers of the bank, each of whom
are buying or selling NOK 4 million?

Certificate in Treasury |150

 a) Customer 1 buying NOK for USD
b) Customer 2 selling NOK for USD
c) Customer 3 selling NOK for EUR
d) Customer 4 buying NOK for EUR
QUESTION 6
LO11
Market FX rates are quoted as follows:
USD/CHF 1.4580-1.4590
GBP/USD 2.0038-2.0041
Your group’s reporting currency is CHF.
Your group needs to buy GBP 1m in order to pay a supplier.
What amount of CHF would the group have to pay to buy the GBP 1m from the quoting bank?

QUESTION 7
LO12
Your organisation needs to obtain a quote for a significant forward FX deal.
Describe the two main methods of obtaining a quote for forward FX deals.
What are the advantages of each method?

QUESTION 8
LO12
You are reviewing a quote from an FX market maker.
The market maker quotes USD/CHF as follows:
Spot 1 month 3 months
1.3920-30 25-28 72-77
What are the full bid and offer rates at which the market maker is willing to deal one month
forward?

QUESTION 9
LO12
A market maker quotes USD/EUR as follows:
Spot 1 month 3 months
0.6220-30 25-22 80-76
What are the full bid and offer rates at which the market maker is willing to deal three months
forward?

Certificate in Treasury |151

QUESTION 10
LO12
You have obtained the following quotations in the market for USD/SEK:
Spot 8.1165-75
6 months forward 8.0750-75
Calculate the 6 months forward points.

QUESTION 11
LO12
Your company deals in USD and THB (Thai Baht). From the quotations below, calculate the 6-
month forward rates for USD/THB.
Spot 1 month 3 months 6 months 1 year
USD/THB 31.4223-33 50-70 185-220 382-455 780-855

QUESTION 12
LO12
Your company deals in USD, CHF and SEK (Swedish Krone). Given the following foreign
exchange quotes:
Spot 1 month 3 months 6 months 1 year
USD/CHF 1.0920-30 28-25 77-72 150-143 322-312
USD/SEK 6.0750-60 60-80 210-230 430-460 750-825
Calculate the exchange rates for:
a) 6-month forward USD/SEK
b) 1-year forward USD/CHF
QUESTION 13
LO13
You work for XYZ Group central treasury.
Group policy is that subsidiaries buy and sell foreign exchange only with the central treasury
that consolidates the overall position each day and deals externally as appropriate with the
group’s banks.
Treasury publishes internal exchange rates each day on the group intranet, based on USD.
You are contacted by a subsidiary that needs to know today’s internal rate for the subsidiary
to sell EUR 5m to central treasury and buy Singapore dollars (SGD) in 6 months’ time.
What EUR/SGD rate (to four decimal places) do you quote to the subsidiary?
XYZ Group internal FX rates:
Spot 1 month 3 months 6 months 1 year
USD/EUR 0.6280-90 48-45 140-135 271-264 205-492
USD/SGD 1.3520-30 28-25 77-72 148-143 322-312

Certificate in Treasury |152

QUESTION 14
LO13
For the benefit of a non-executive director, explain why forward foreign exchange rates
normally differ from spot foreign exchange rates.

QUESTION 15
LO13
For the benefit of the chief executive officer, describe the main principles of the interest rate
parity theory.

QUESTION 16
LO13
Calculate the expected 6-month (181-day) forward FX rate if the current spot FX rate is
USD/CHF 1.0227, and 6-month interest rates are 2.75% in USD and 3.25% in CHF.

QUESTION 17
LO13
Your organisation needs to borrow EUR 50m for 182 days.
You have been quoted a rate of 3.75% to borrow EUR.
Alternatively you could borrow USD at a rate of 3.25% and swap the proceeds for EUR.
USD/EUR is currently trading at a rate of 0.6337, and you have been quoted forward points of
+ 15.
a) Why might you investigate the USD borrowing in these circumstances?
b) Which method of obtaining the EUR required is cheaper, and by how much?

ANSWERS
ANSWER 1
Key features of the foreign exchange (FX) markets include:
 substantial trading volume results in a highly liquid market
 the large volumes of trading, geographical dispersion and range of factors that can
influence FX rates all mean that FX rates can change very quickly
 due to the number of participants and size of the markets, market makers’ profit margins
are normally a low proportion of any individual transaction
 FX markets are increasingly technological and while the telephone is still used for some
limited purposes, most prices are posted and deals struck electronically
 the foreign exchange markets are dominated by traders who take speculative positions –
effectively a ‘bet’ on the strengthening or weakening of particular currencies. The traders
may work for a bank or for institutions such as hedge funds
 there is a need for non-financial organisations to buy and sell foreign currencies in order
to make currency payments or to convert currency receipts. Even so, the total volume of
these transactions remains relatively small, compared with the large volume of
speculative activity
 he foreign exchange markets facilitate the movement of capital around the world.

Certificate in Treasury |153

ANSWER 2
Even if electronic dealing solutions are available, most corporates will maintain telephone
contact with their bank’s corporate dealing desk because most treasurers will wish to collect
intelligence on the market. The bank may also offer more favourable rates for certain
customers, or deal sizes not apparent on screen. However, most medium to large treasuries
will now transact most deals using web-based portals. These have the advantages that:
 there is less opportunity for misunderstanding or inappropriate deal pricing
 confirmation is immediate
 multi-bank portals give competitive pricing, i.e. quotes from more than one bank
 they facilitate straight-through processing.

ANSWER 3
In the major developed economies there is no official rate of exchange and the national
currency usually floats freely against other currencies. In this context, the central bank plays
two main roles:

 it supervises markets within its jurisdiction

 it maintains control over the supply of money and domestic interest rates, which will
influence the attractiveness of the currency to foreign investors.

The central bank may seek to smooth out fluctuations in currency movements by buying and
selling currency in the markets, often working together with other central banks around the
world.

ANSWER 4
A spot foreign exchange deal is an agreement to exchange currencies (almost) immediately.
In practice spot deals are generally settled two working days after the date when the deal is
entered into, as this is the earliest timing that can be guaranteed to work irrespective of time
zones.
A forward foreign exchange deal is one having a settlement date which is further into the
future, compared with a spot deal.

ANSWER 5

a) Customer 1, buying NOK 4m for USD

The FX quote is:
USD 1 = 4.9839 - 4.9849 NOK
The customer is buying NOK.
The customer will therefore receive the fewer NOK, namely 4.9839, per USD 1 paid.
The amount of USD paid by the customer, in exchange for receiving NOK 4m, is:
4,000,000/4.9839
= USD 802,584 (cost)
(To the nearest USD 1)

Certificate in Treasury |154

b) Customer 2, selling NOK 4m for USD
The second customer is selling NOK 4 million in exchange for US dollars.
The customer will therefore pay more NOK, namely 4.9849, per USD 1 received.
The amount of USD received by the second customer, in exchange for paying NOK 4m, is:
= 4,000,000/4.9849
= USD 802,423 (receipt)

Sense check
The customer selling NOK gets a lower USD receipt (USD 802,423) compared with the amount
payable to buy the same amount of NOK (USD 802,584 payment).
As expected.

c) Customer 3, selling NOK for EUR

In summary, for the third customer selling NOK 4m in exchange for EUR, the price would be
worked out via the respective rates for USD/NOK and for USD/EUR, and notionally exchanging
USD.
This is a cross rate calculation via USD.

Summary
Dealing on the worse side of each quote for the customer:
Sell NOK 4m for:
4,000,000/4.9849
= USD 802,423.32
Sell the USD 802,423.32 for:
802,423.32 × 0.6325
= EUR 507,533 (received)

Full workings and explanation

The customer pays away NOK 4m, and ultimately receives EUR.
This is achieved via notionally:
 selling NOK for USD, then
 selling the USD for EUR.

i) Selling NOK 4m for USD

The FX quote is:
USD 1 = 4.9839-4.9849 NOK
The customer selling NOK will give the larger number of NOK (per USD 1 received) namely
4.9849 NOK (per USD 1).
The customer would notionally receive 4,000,000/4.9849
Certificate in Treasury |155
= USD 802,423.32
(working to the nearest USD 0.01 here, to avoid any rounding errors later)

ii) Selling USD 802,423.32 for EUR

The FX quote is:
USD 1 = 0.6325-0.6335 EUR
The customer paying USD will receive fewer EUR, namely 0.6325 EUR (per USD 1 paid to the
bank).
The receipt from the (notional) sale of USD 802,423.32 is:
802,423.23 × 0.6325
= EUR 507,533 (receipt)
(This is exactly the same result as would be obtained from physically exchanging USD for each
of NOK and EUR in turn.)

d) Customer 4, buying NOK 4m for EUR

Similarly, in summary, a fourth customer buying NOK 4 million for EUR would also deal
notionally in each of USD/NOK and USD/EUR, on the worse side of each quote.
This is a cross rate calculation (via USD).

Summary
Buy NOK 4m for:
4,000,000/4.9839
= USD 802,584.32
Buy the USD 802,584.32 for:
802,584.32 × 0.6335
= EUR 508,437

Full workings and explanation

The customer pays EUR, and ultimately receives NOK 4m.
This is achieved via notionally:
 selling EUR for USD, then
 selling the USD for NOK.

i) Selling EUR for USD

The FX quote is:
USD 1 = 0.6325-0.6335 EUR
The customer paying away EUR will give more EUR (per USD 1 received).
This is 0.6335 EUR.

Certificate in Treasury |156

So the rate applying to the notional sale of EUR for USD will be:
USD 1 = 0.6335 EUR

ii) Selling the USD for NOK

The FX quote is:
USD 1 = 4.9839-4.9849 NOK
The customer receives NOK.
So the number of NOK received will based be the lower figure, namely NOK 4.9839.
The number of USD payable, to receive NOK 4m, is:
4,000,000/4.9839
= USD 802,584.32
(to the nearest USD 0.01 in this intermediate working)

Selling EUR to receive USD 802,584.32

The USD to be sold is (from b))
USD 802,584.32
The rate applying is (from a))
USD 1 = 0.6335 EUR
So the amount of EUR to be paid is:
802,584.32 × 0.6335
= EUR 508,437 (cost)
(The same result would be obtained by physically exchanging the USD.)

Sense check
The customer buying NOK pays a greater EUR amount (paying EUR 508,437) compared with
the amount received by the customer selling the same amount of NOK (receiving EUR
507,533).
As expected.

ANSWER 6
The group would have to pay CHF 2,923,982 to buy the GBP 1m.

Workings
a) As the market taker, notionally buy GBP 1m for USD at the worse rate.
This is GBP 1 = 2.0041 USD, paying more USD per GBP 1 received.
USD paid:= 2.0041 × 1,000,000= USD 2,004,100
b) Notionally buy these USD 2,004,100 for CHF at the worse USD 1 = CHF rate.
This is USD 1 = 1.4590 CHF, paying more CHF per USD 1 received.
Certificate in Treasury |157
CHF paid:= 1.4590 × 2,004,100= CHF 2,923,982
This is a worse rate for the buyer of GBP.
The buyer has to pay more CHF per GBP 1 (or GBP 1m) received.

ANSWER 7

Method 1: an outright forward price

The corporate asks the bank to quote a single forward FX price consisting of the combination
of the spot rate and the forward points.
The main advantage for less active treasuries and for smaller organisations is that it is both
simple and clear.

Method 2: separate spot rate and forward points

Advantages include:
 it reflects the way that the bank itself constructs an outright forward FX rate
 it is more transparent – both elements can be quoted competitively and compared with
screen rates
 as spot FX rates tend to be more volatile than the forward points in a moving market some
treasurers prefer to lock in the spot FX rate first.

The two elements (spot FX rate and forward points) can be separated and dealt with different
counterparty banks if the resulting difference in prices warrants such an approach.

ANSWER 8
The full bid and offer rates at which the market maker is willing to deal 1-month forward are:
USD 1 = 1.3945-1.3958 CHF
The points 25-28 are Ascending, so Add them.

Workings
Spot 1.3920 1.3930
Points + 0.0025 + 0.0028 Add
Forward 1.3945 1.3958

ANSWER 9
The full bid and offer rates at which the market maker is willing to deal 3-month forward are:
USD 1 = 0.6140-0.6154 EUR
The points 80-76 are Descending, so Deduct them.

Certificate in Treasury |158

Workings
Spot 0.6220 0.6230
Points (0.0080) (0.0076) points Descending, Deduct
Forward 0.6140 0.6154

ANSWER 10
The 6-months forward points are the difference between the 6-months forward FX rates and
the spot FX rates:
Spot rate 8.1165 8.1175
less: 6 months forward rate 8.0750 8.0775
Difference= 6m forward points 0.0415 0.0400
So, the 6-months forward points are 415-400.

ANSWER 11
Spot 31.4223 31.4233
Points + 0.0382 + 0.0455 points Ascending, Add
Forward 31.4605 31.4688

ANSWER 12
a) The 6-month forward points for USD/SEK are 430-460. These points are Ascending, so Add
them.

6-month USD/SEK
Spot 6.0750 6.0760
Points + 0.0430 + 0.0460 points ascending, Add
Forward 6.1180 6.1220
Notes:
 base currency is more expensive forward ‘at a premium’
 right-hand forward points are higher (points ascending)
 Add the forward points.

b) 1-year USD/CHF
Spot 1.0920 1.0930
Points (0.0322) (0.0312) points descending, Deduct
Forward 1.0598 1.0618

Certificate in Treasury |159

Notes:
 base currency USD is cheaper forward ‘at a discount’
 right-hand forward points are lower (points descending)
 deduct the forward points.

ANSWER 13
Subsidiary selling EUR for SGD for value 6 months forward,
This is a forward cross rate calculation via USD.
The forward cross rate is worked out via the respective forward rates for USD/EUR and for
USD/SGD, and notionally exchanging USD at the forward rates.

Summary
USD/EUR 0.6290 less 0.0264 = 0.6026
USD/SGD 1.3520 less 0.0148 = 1.3372
EUR/SGD rate = 1.3372/0.6026
= 2.2191
EUR 1 = 2.2191 SGD

Full workings, via EUR 5m

The subsidiary will sell EUR and buy SGD.
Calculated via USD:
a) Sell EUR for USD and
b) Sell USD to receive SGD

a) Selling EUR for USD (6 months)

The forward points 271-264 are descending, so deduct them from the spot FX quote to
calculate the two-way forward FX quote:
0.6280 0.6290
(0.0271) (0.0264)
0.6009 0.6026
USD 1 = 0.6009-0.6026 EUR
The customer is paying EUR.
So the customer will pay more EUR per USD, received.
This is 0.6026 EUR.
Selling EUR 5,000,000 at USD 1 = 0.6026 EUR would give a receipt of:
5,000,000/0.6026
= USD 8,297,378.03

Certificate in Treasury |160

b) Sell USD 8,297,378.03 to receive SGD
The 6-month forward points 148-143 are descending, so deduct them from the spot FX quote:
1.3520 1.3530
(0.0148) (0.0143)
1.3372 1.3387
USD 1 = 1.3372-1.3387 SGD
The customer selling USD for SGD will receive the fewer SGD.
This is SGD 1.3372 per USD 1 sold.
= 8,297,378.03 × 1.3372
= SGD 11,095,253.90
In exchange for EUR 5,000,000 this is a rate of:
11,095,253.90/5,000,000
= 2.2191
EUR 1 = 2.2191 SGD

ANSWER 14
Forward foreign exchange rates normally differ from spot FX rates, because of interest rate
differentials.

ANSWER 15
The interest rate parity (IRP) theory describes the relationship between the spot FX rate, the
forward FX rate, and the interest rate difference between the two related currencies.
If the IRP relationship did not hold good, then it would be possible to make risk free ‘arbitrage’
profits by dealing simultaneously in an appropriate combination of the related foreign
exchange and interest rate instruments.
For this reason arbitrage activity in the markets will cause rates to re-converge rapidly to the
‘no arbitrage’ relationship predicted by IRP theory.

ANSWER 16
The periodic interest rate for 6 months’ maturity is greater in CHF.
This means that CHF will be weaker in the forward market (‘at a discount’) compared with the
spot FX rate of:
USD 1 = 1.0227 CHF
This means a greater number of CHF per USD 1.
The forward FX rate will therefore be a greater number of CHF per USD 1:
1.0227 × (1 + (0.0325 × 181/360))/( 1 + (0.0275 × 181/360))
= 1.0252 CHF
USD 1 = 1.0252 CHF

Certificate in Treasury |161

ANSWER 17
a) In simple terms, it might turn out to be cheaper to borrow via the USD route rather than
directly in EUR.
All other things being equal, we’d normally prefer to use the most cost-effective source of
funding.
b) We will compare the cost of:

 Direct borrowing in EUR

 A swapped USD borrowing

i) Direct borrowing in EUR

Direct EUR borrowing for 182 days.
Interest = EUR 50,000,000 × 0.0375 × 182/360
= EUR 947,917
Total repayable = EUR 50,947,917

ii) Swapped USD borrowing

Steps:
A) Amount of USD to borrow
B) USD repayable
C) EUR repayable
A) Amount of USD to borrow:
We need EUR 50m and the spot FX rate is USD = 0.6337 EUR
We will borrow:
50,000,000/0.6337
= USD 78,901,688.50
B) Calculate USD repayable:
We will repay USD of:
78,901,688.50 × (1 + (0.0325 × 182/360))
= USD 80,198,087
C) Calculate EUR repayable:
The forward FX rate is:
0.6337 + 0.0015
USD 1 = 0.6352 EUR
EUR repayable
80,198,087 × 0.6352
= EUR 50,941,825

Certificate in Treasury |162

This appears to be cheaper than the direct borrowing in EUR.
The potential saving from using the swapped USD borrowing is:
50,947,917 – 50,941,825
= EUR 6,092

Certificate in Treasury |163

Index
Abbreviated FX quotations 129 Converting periodic yield (r) to periodic
Abbreviations (k, m and bn) 52 discount rate (d) 69
Accounting 22 Converting the year basis (360 v 365-day year)
Adjusting for forward points 138 56
Advisory 11 Core resources and learning outcomes 42
Agency 12 Corporate finance 30
Alignment of treasury policy with local needs Corporate financial management 29
16 Cost centre 13
Analysis and interpretation of data 43 Cost saving 15
Analysis of working capital 29 Cost saving centre 13
Analysis, decision making, execution, Coupon bond 76
approval, settlement and accounting 20 Currency codes 127
Annuities 90 Currency management 29
Annuity factor 90
Approval 25 Day count conventions 55
Arbitraging between the spot FX rate, interest Days between two dates 55
rates and the forward FX rate 146 Days in a conventional year 56
At a premium or at a discount 137 Dealing errors 125
Dealing methods 125
Back and middle office 21 Decentralised treasury structures 16
Back office roles 20 Deferred perpetuities 91
Bank relationship management 30 Definitions 54
Banks and credit lines 125 Deriving simple annual rates 59
Basis points 54 Differences between spot and forward foreign
Booking a rate 126 exchange rates 134
Broken dates 135 DIFFERENT SIDES MULTIPLY SAME SIDE 132
Brokers 125 Discount amount 67
Buying and selling foreign currencies 128 Discount factor calculation 50
Discount factors 86
Calculating actual days 55 Discount instruments 67
Calculating IRR by straight-line estimation 88 Dividing by FX rates 49
Calculating rates of return 47 Drawbacks 15
Calculating redemption value and yield 65 Drivers of FX transactions and FX rate
Calculating spot cross rates 131 movements 124
Calculation from the spot FX date 135 Duplication 17
Capital markets and funding 30 Dynamic balance 18
Cash and liquidity management 28
Cash management 28 EAR 111
Centralised treasury structures 14 Effective annual rate (EAR) 60
Commitment and confirmation 125 Effective annual rate calculation: 61
Comparing instruments on a like-for-like basis Expressing financial relationships in equations
(EAR) 71 43
Compound interest for multiple periods: 59
Compound interest rates 59 Factors and financial objectives influencing
Control 15 the structure of treasury 10
Control and reporting 19 Financial risk management 31
Controls and segregation of duties 22 Finding unknown items: solving equations 44
Conversion between periodic discount rate First cash flow 119
and periodic yield 68 Forecasting need for funds 46
Convert periodic yield to EAR 71 Forecasting return on investments 46
Converting between discount and yield 68 Foreign exchange (FX) rates 48
Converting forward and zero coupon rates 79 Foreign exchange risk management 135
Converting nominal annual yields (R) to EAR Foreign exchange swaps calculations 140
71 Foreign exchange swaps principles 140
Converting par rates to zero coupon rates 83
Certificate in Treasury |164
Forward and zero coupon yields relationship Market expectations 75
79 Market makers 124
Forward foreign exchange cross rates 138 Market segmentation 76
Forward foreign exchange rate quoting Market takers 125
conventions 135 Middle office roles 21
Forward FX rates 134 Millions and billions 53
Forward rate 76 Monitoring cash flow 45
Forward rates to zero coupon rates Multiple cash flows 86
conversion steps 80
Forward yield curve 77 Named rates 62
Front office 20 Need for suitably qualified staff 17
Front office, back office and middle office Net present value (NPV) 87
roles 20 Nominal annual discount rate (GBP 365-day
Funding management 30 conventional year) 107
Future value 49 Nominal annual discount rates to nominal
FX swap to ‘roll’ original trade forward 140 annual yields 70
Nominal annual rates 62
General responses to risk 31
Growing perpetuities 92 Objectives and role of a treasury department
Growing perpetuity 119 8
Guideline for combining quotes 131 Operational and strategic functions of
treasury 27
How discount instruments are quoted 107 Operational responses 31
How foreign exchange rates are quoted 127 Organisational responses 31
How treasury supports the objectives of an Other relevant factors when comparing
organisation 8 instruments 74
Outsourcing treasury activities 23
Identifying the spot date 130
Identifying when cash flows occur 85 Par bond 76
Immediate payments and receipts 126 Par rate 76
Implementation 25 Par yield curve 76
Implied forward FX rates 144 Participants in foreign exchange rate markets
In-house bank 12 123
Interest 54 Periodic discount rate 107
Interest rate parity and implied forward rates Periodic discount rate to periodic yield 69
143 Periodic interest rates 58
Interest rate parity formula 144 Perpetuities 91
Interest rate parity in practice 144 Present value 49
Internal rate of return 118 Present value formula 85
Internal rate of return (IRR) analysis 88 Present values and discounting 85
Investment management 30 Profit centre 13
Issue proceeds 107
Rates including inflation 62
Key contents 24 Rates of return and growth rates for multiple
Key definitions in understanding yield curves periods 48
76 Rates used 131
Linking interest rates to FX transactions, Real growth rates 63
including the use of money market hedges Real interest rates 62
147 Real rates 62
Liquidity management 29 Real terms cash flows 93
Liquidity preference 76 Real terms evaluations 92
Local autonomy 16 Real terms evaluations work in theory 93
Loss of control 17 Rearranging an equation 44
Loss of economies of scale 17 Redemption value calculation 65
Regulatory environment 14
Management 21

Certificate in Treasury | 2
Relationship management with key internal The time value of money 49
and external stakeholders 32 Thousands 52
Risk appetite and culture and their impact on Total cash at end of investment 47
treasury’s structural response to risk 12 Total present value 119
Risk management 40 Treasury authority 13
Round appropriately for the context 50 Treasury operations and controls 32
Round, don’t truncate 51 Treasury policy 24
Rounded result 50 Types of market participants 124
Rounding and spurious accuracy 50 Types of yield curve 76
Rounding errors 51
USD discount instrument 72
Same side cross divide 131 USD yield instrument 71
Selling EUR to receive USD 802,584.32 157 USD/SEK 159
Sense check 155 Using credit or debit cards 126
Sensitivity analysis 43 Using the annuity valuation formula 117
Sensitivity tables 43 Value dates for forward exchange 135
Set up and solve an equation 45 Value of money in different currencies 48
Short-term discount rates 54
Short-term nominal annual discount rate What functions should be outsourced? 23
calculation 67 When periodic rates rise for subsequent
Short-term rates 57 same-length periods 78
Simple interest rates 57 Which side of the quote? 128
Single financial status 14 Whole months 59
Size and location 123 Why EAR is a higher number 71
Skills needed to successfully fulfil these Why nominal terms evaluations are usually
positions 21 preferable 94
Smaller transactions 126 Why real terms evaluations can be useful 94
Spot FX rates 134 Why yields differ for different maturities 75
Spot transactions including identifying the
spot date 130 Yield and redemption value 65
Spurious accuracy 52 Yield calculation 66
Straight-line estimation formula 89 Zero coupon and par rates relationship 82
Substituting into the formula 117 Zero coupon bond 76
Synergy of expertise 15 Zero coupon rate 76
Zero coupon rates to forward rates conversion
Target closing borrowings 44 steps 79
Technology 14 Zero coupon rates to par rates conversion
Telephone dealing and web-based portals 125 steps 82
The ‘end end’ rule 135 Zero coupon yield curve 77
The activities and process for undertaking
treasury deals 19
The Eurocurrency market and its role in
setting forward FX rates 145
The finance director and finance department 7
The foreign exchange (FX) market 122
The no arbitrage relationship between yield
curves 77
The objectives of the organisation and the role
and actions of treasury 8
The role and responsibilities of the finance
director, finance department and treasurer 7
The role of central banks 124
The role of the treasurer 7
The role of treasury within an organisation 11
The structure of the finance function 6
The term structure of interest rates 75

Certificate in Treasury | 3
 GET YOURSELF EXAM READY
The study guide for each unit of the Certificate in Treasury
has been written to help you achieve your qualification.

Focused syllabus coverage

Syllabus references showing where each syllabus
learning outcome is covered
Suggested study hours to guide your personal
study program
Practical examples to illustrate theory and concepts
Self-assessment exercises to reinforce your understanding
Direction to online resources including short
quizzes and further reading.

CERTIFICATE
ABOUT THE ACT
The ACT is the only international chartered body to set the benchmark for treasury excellence.

IN TREASURY
Our competency framework sets the standards for the skills, knowledge and behaviours treasurers,
or those working with treasurers, need at each stage of their career. Achievement of these standards
is measured and recognised by our globally delivered suite of qualifications.

The ACT Competency Framework defines The content of this syllabus introduces the skills
the key responsibilities, skills, knowledge required to operate at an operational level.
and behaviours needed to be effective when
working in or with the treasury profession. STUDY GUIDE: UNIT 1
It was developed in consultation with Strategic Level
practitioners from treasury, financial Managerial Level
services and learning and development.
To help you identify which competencies Operational Level
are relevant to you, we’ve mapped them to Tactical Level
4 job levels: tactical, operational, managerial
and strategic. This guide is aimed at
supporting those in managerial level roles. treasurers.org/competencyframework

FOLLOW US CONTACT US
@ACTupdate The Association of Corporate Treasurers
facebook.com/actupdate T +44 (0)20 7847 2529
E [email protected]
treasurers.org/linkedin
youtube.com/treasurersorg

academy.treasurers.org