I graduated from a UK university with the degree of BA (Hons) Banking, and currently study Master’s in Nottingham University with the subject of Risk Management. I have a wide range of experience in banking, financial markets, risk management, insurance as well as corporate strategy.

Sample

Corporate Treasury Management for Abbot Group

Introduction

Abbot Group is the largest offshore platform drilling contractor in the UK sector of the North Sea, one of the largest international land-drilling operators outside North America, and a world leader in drilling rig design, construction and operation. The Group mainly operates in the Caspian region, Russia, the Middle East, Africa and Asia (Abbot Group, 2003).

In 2003, Abbot Group has made pre-tax profits of £30.8m, a rise of 29%, and a decrease in terms of the total turnover (Abbot Group, 2003). Abbot Group is currently exposed to currency risk in the US dollar, which is the principal currency in the oil industry and exposed to Sterling and Euro denominated trading and loan balances within the overseas subsidiaries (Abbot Group, 2003).Therefore, it is necessary for the Group to apply adequate hedging instruments for various risks where it faces, and minimises these risks.

A hedge is an action taken by a company to cover itself against risk. It is normal procedure for companies to adopt sufficient hedging methods for protection. Failure to manage essential hedging will incur a loss on the company’s profit, such as Volkswagen which has lost over $300m during the 1980s, as it failed to cover foreign exchange exposures (Ochynski, 2003). In addition, hedging is a way of reducing risks, rather than increasing the return of the company, as the Risk Management Survey 2003 concluded that “the majority of companies cite ‘minimizing risk’ (55%) as the most important risk management objective.” (Bank of America, 2003).

This report will review the current situations of risk exposures on currency risk and interest rate risk of Abbot Group, and recommend the possible hedging solutions for each of these risks, and then liquidity exposure will be reviewed. Based on the above risk exposures, this report will discuss whether the Group should adopt relationship banking or transaction banking.

Currency risk

Currency risk is defined as the risk that a business’ operations or an investment’s value will be affected by changes in exchange rates. This risk commonly exists to affect the corporate (ADVFN, 2004?). Generally speaking, currency risk is classified under three main categories: transaction, translation and economic risks. Before reviewing the currency exposure of Abbot Group, a simple question needs to be answered: should the Group hedge against currency risk?

By way of corporate hedging against currency risk, the Group will certainly gain several advantages, such as the reduction of volatility of profits and future cash flows, lower cost of capital, lower risk of financial distress which may increase the debt capacity for the Group, and other companies or customers prefer to deal with the less risky company (Cowdell, Hyde and Watson, 2000).

However, there has been considerable academic debate on whether currency risk should be managed by the corporate. There are mainly three groups of arguments which are against the corporate hedging:

The first theory is the Purchasing Power Parity Theory (similar theories may include Self-Insurance and Market efficiency) (PPP). It suggested that movements in exchange rate are offset by the changes in price levels, and it would be unnecessary for the Group to hedge against it. If PPP is applied, then any changes in the £:$ rate would be offset by changes in relative price levels, and similarly with the £:€ rate and other foreign exchange rates. However, the PPP seems to be more valid over long terms, so that any single large loss on foreign currency could get the group into serious trouble, such as recently with the sharp drop in the £:$ rate (Buckley, 2004). Therefore the PPP theory is not applicable for the Abbot Group.

The second argument is that, with the Capital Asset Pricing Model (CAPM),the corporate doesn’t need to adopt hedging methods as the shareholders can hold diversified portfolio of shares to eliminate unsystematic risk, and it will add no extra value to shareholders if currency risk is systematic (Cowdell, Hyde and Watson, 2000). However, CAPM ignores the existence of transaction costs, such as bid-offer spreads and default risks as applied to Abbot Group, all these costs may arise from an unhedged position. In addition, similarly with PPP theory, if the group is in the unhedged position, and large unfavourable changes in exchange rates occur, this movement could lead to serious liquidity issues (Buckley, 2004). So, CAPM is not eligible for the Abbot Group.

The final argument is the Modigliani and Miller (MM) proposition 1958. It looked at corporate gearing, which is the extent to which a business is financed by outside parties, and suggested that shareholders in the Abbot Group could hedge currency exposure by themselves; there is no need for the group to hedge currency exposure repeatedly. However, although the suggestion of MM seems to be better than others, it is doubtful whether the shareholders have sufficient time and information, as well as the expertise to manage their portfolios, especially the insider information which is hard to obtain (Buckley, 2004). In addition, although the individual shareholder is willing to adopt hedging instruments, some techniques of hedging are truly only available at the corporate level, so that it would be hard for shareholders to manage their portfolio successfully. Therefore, the MM argument is not applicable for the Abbot Group.

The hedging philosophy suggested that there are three main types of hedging, which are hedging nothing, hedging selectively and hedging everything. According to the above arguments and theories, it is unlikely for the Abbot Group to adopt an unhedge policy. In addition, as the Abbot Group is not a price maker, so that the “hedging everything” policy is not affordable. With the corporate gearing ratio dropping in 2003, together with a huge cash inflows, a “hedging selectively” policy would be appropriate for the Abbot Group.

The Abbot Group is currently hedging 50%-75% of its exposure to movements in foreign exchange rates. In terms of internal hedging technique, because over 60% of the group’s turnover is earned in US dollar and Euros, it is necessary for the group to have foreign currency bank accounts for any foreign receipts and payments (Abbot Group, 2003). By using the foreign currency bank accounts, the group can avoid consistently buying and selling the same currency and keep away from the bank’s bid-offer spreads, so that the group can maximise the natural hedge against currency fluctuations (Cowdell, Hyde and Watson, 2000). However, problems may arise because the transaction is carried out between the group’s foreign subsidiaries and its UK companies.

Recommendation on internal hedging techniques for the Abbot Group would be the Multilateral Netting, with the management of cross-border payments resulting in a net receipt or payment to each entity in their local and/or preferred currency (Shuffrey, 2000). By adopting this method, the group will reduce the transaction costs, as the number of transfers has been reduced, as Shapiro (2003, p647) found out that “many companies can eliminate 50% or more of their intercompany transactions through multilateral netting”. More importantly, multilateral netting has reduced the opportunities of facing foreign exchange exposures, as either foreign receipts or payments have been processed in less numbers, therefore, leading to lower contact with exchange rates.

The Abbot Group heavily uses external hedging techniques to maintain the exposure on movements of foreign exchange rates. In order to hedge currency exposure, the group has mainly used forward sales contracts as hedging instruments, for a period of 12 to 18 months, and the Abbot Group has successfully hedged the exposure in US dollars under the current dollar’s depreciation trend (Abbot Group, 2003). The forward contract can help the Abbot Group easily realise the cost of both future foreign currency payments and receipts, and this is crucial for the group who mainly worked as a contractor. In addition, forward contract is flexible to use, either early or extended, and the Abbot Group doesn’t need to consistently monitor the exchange rate movements. However, forward contracts cannot eliminate the economic risks, especially when exchange rates move in the group’s favour after signs the contracts.

Surprisingly, the group didn’t hedge against translation risk in 2003 (Abbot Group, 2003). Compared with hedging on transaction risk, the group is more willing to hedge against the real cash flow, rather than the pure accounting figures, as Ross, Clark and Taiyeb (1987) quoted that “as a very general first principle, it is uncommercial to hedge a non-cash item with a cash one” (Buckley, 2004).

However, it is questionable whether the group needs to hedge against translation risk. With over 60% of foreign currency turnover, together with the denominated currency in the oil industry is US dollars, it will pose a real threat to the balance sheet date, as all the turnover will be exchanged at spot rate on that day. In addition, although the group could possibly hedge the balance sheet exposure by using forward contracts, the amount of contracts will be subject to the creditworthiness of the Abbot Group, therefore, the group needs to be careful with other signed forward contracts, and avoid any late or non-payments. The possible solutions to translation risk could be the use of foreign currency borrowing or matching.

A recommendation on an external technique of hedging currency risk could be currency options. The option gives the benefit of protecting against an adverse movement in the exchange rate, as well as allowing the group to benefit if the exchange rate moves in its favour (TreasuryToday, 2001). In addition, currency options are more preferable for the Abbot Group where a future currency cash flow is uncertain as in the case of a tender on a contract or an overseas takeover bid (Buckley, 2004). However, the group has to pay non-returnable premiums on using the currency options, which may be an unnecessary expense. Moreover, as the principle of the group is not holding derivative investments for speculative purposes, in this case, the group may use currency options to purely hedge against any uncertain future currency cash flow, as well as the balance sheet exposure, therefore, only hold a considerable number of options (Abbot Group, 2003).

Interest rate risk

At the simplest level, interest rate risk is the adverse effect on a company’s profitability if the interest rate changes (Douch, 2002). A change in interest rates, can affect the group’s operations by altering costs of borrowing and the levels of purchases.

During 2003, the Abbot Group made an enormous alteration to the interest rate liabilities, which changed from 25% floating rate (floating interest rate means the borrowing cost is adjusted at frequent intervals to take account of changes in market rates) to 75% fixed rate (fixed interest rates are unchanged irrespective of whether market rates rise or fall) in 2002 to 50% respectively (fixed rate includes the amount of fixed rate interest liabilities and the amount of liabilities on which no interest is paid). This was because of the substantial reduction in the amount of debt through the sale of the group’s division (debt structure will be discussed in Liquidity Risk later) (Abbot Group, 2003). By the re-structure of interest liabilities, Abbot Group has certainly achieved a natural hedging position, even if the uncertainty has increased, because of the decrease in amount of fixed interest rate liabilities. In addition, the national LIBOR has decreased since 2001, as Chart 1 shows:

Chart 1: LIBOR 3-month Trends

Source: Fannie Mae, 2004

As Chart 1 shows, the three-month LIBOR has dramatically reduced in 2001, mainly caused by the stock market crash, and showed a slight recovery in late 2003. Under this circumstance, as Douch (2002, p. 51-52) quoted “a company will borrow floating when it expects interest rates to fall further than the fixed rate”, therefore the group did switch its policies during this time.

During 2003, the market predicted that the UK base rate would increase in the near future, mainly because of the tremendous rise in the house market, as well as the falling trend of the US interest rate, as Chart 2 and Chart 3 show:

Chart 2: UK Base Rate Trends

Chart 3: US Interest rate Trends

Source: Bank of England, 2004 Source: Fed Reserve,2004

As Chart 2 shows, the UK base rate was decreasing until the middle of 2003, and increased 0.25 to 3.75% by the end of 2003, whereas Chart 3 shows the US interest rate incurred a huge drop in 2001 and reached its lowest point of 1% in 2003. Under these trends, the group decided to convert £25m debt into US dollars, and used the difference between the two rates to compensate the losses on US dollar debtors (Abbot Group, 2003). In addition, because the main turnover of the group is in US dollars, there was no harm in putting both payments and receipts in dollars, and achieving a natural hedging position.

Surprisingly, the group has cancelled the interest rate swap during 2003, mainly because of the swaption of debt into US dollars (Abbot Group, 2003). There is no doubt that interest rate swap is a useful and flexible tool for managers to make necessary hedging against interest rate risk. However, with the conversion of £25m debt, which means the group has changed its borrowing repayment strategy, and already re-adjusted between floating rate and fixed rate, together with the higher interest rate cover, which is 10.6 times in 2003, there is no need for interest rate swap to be carried out (Abbot Group, 2003). Therefore, in 2003, the Abbot Group mainly used internal techniques for managing interest rate risk, rather than use any derivatives instruments.

Although US and UK interest rates have reached the lowest point in 2003, the uncertainty is still a risk faced by the Abbot Group, as TreasuryToday (2003) quoted that “even at a low level, interest rate changes still have the potential to adversely affect the profitability of a company.” In addition, even if the group has made a better profit and surplus cash in 2002, with the current rising trends in both US and UK interest rates, it is necessary for the group to adopt an adequate hedging policy, such as the use of derivatives.

To recommend the group, an interest rate option would be appropriate, such as cap, floor or collar. With an option in hand, it could protect Abbot Group against increases in interest rates, as well as provide certainty. In addition, the option allows the Group to benefit from lower interest rates without any limitation, as long as the interest rate stays below the strike price, the group will benefit from lower rates. Furthermore, the interest rate option is flexible; it can be arranged over-the-counter, and can be sold back to the bank during the option period. However, the interest rate option will depend on the credit of counterparty regarding any payment. In addition, there is an upfront premium which has to be paid (Buckley, 2004). Unlike interest rate swap, the interest rate option is more flexible, mainly because the rate of borrowing is fixed once a swap is exercised, whereas the Abbot Group could continue to enjoy any benefits of favourable movements in the interest rate option.

To summarise, the Abbot Group needs to use the interest rate option to minimise the risks of raising interest rates, while the group could also continue use the currency swap on its debt, and benefit from the lower rates in US dollars.

Liquidity Risk

Liquidity risk is a financial risk due to uncertain liquidity, such as the corporate short-term need for cash, reputation and the liquidity of the corporate assets (RiskGlossary, 2004?). It is crucial for the corporate to manage their working capital, short-term borrowings and cash, as a result of minimising liquidity risk.

In 2003, the Abbot Group was considered (delete ‘as’)less risky, because of the lower gearing ratio, from 37.2% to 15.6% in 2002, and the reduction in terms of its debtors and total debts, together with more cash being generated (Abbot Group, 2003). In addition, the conversion of £25m into US dollars will be used to repay the group’s revolving credit facility and loan stock facility (Abbot Group, 2003).

Bank loans and overdraft facilities are the main borrowing methods for the Abbot Group. It is necessary for the group to have these borrowing facilities, as when the group signed the contracts, it did not get the receipts initially, so that the Abbot Group needs to have loans or overdrafts in advance to fulfil these contracts. In addition, the percentage between short-term and long-term is roughly equal, however, short-term borrowing has the benefits of lower interest rates and more flexibility, whereas long-term borrowing could be used for matching with the nature of the assets held (Atrill, 2000).

Moreover, it is important for the Abbot Group to have a disaster plan, which is a scenario of downturn of the group, and possible cash generating activities such as cost cutting or sale of assets. More importantly, the plan must be briefed to the group’s relationship bankers, so that emergency short-term borrowing facilities could be arranged.

Relationship/Transaction Banking

It is crucial for the corporate to decide what relations it is likely to hold with banks, it could be either relationship-based or transaction-based. From the bank’s point of view, the relationship banking is trying to maximise the profits of total customer relationship. On the other hand, transaction banking is to maximise the profits of each individual transaction taken in isolation.

It is obvious for the corporate to recognise the benefits of each relation with banks. Compared with transaction-based, corporate will be likely to receive better benefits through relationship banking, such as mutual understanding of corporate goals and objectives, the willingness of banks to support them in times of downturn, as well as the competitive pricing which relationship banking will offer.

However, a research by StreamVPN (2002) has found out that “corporate still perceive banks to be more ‘product’ than ‘client’ focused, despite that most banks are more customer driven. In addition, trusted relationships are crucial and by far the most important factor when clients award transaction mandates, and 40% of treasurers had systems in place to measure a bank’s performance, however, they are more transaction-defined measures” (Hodges, 2002, p24-25).

With different benefits of each relation, it is up to the corporate to decide which relations it is likely to use, and it needs to base the decision on the policies and strategies of the corporate. For the Abbot Group, it is currently using Bank of Scotland as its relationship bank, and most of its overdrafts and bank loans are borrowed through this bank. This relationship has been in place since 2000, and the group has certainly received benefits, such as the large multi-option facility which will be reviewed each year, and the limit has been steadily increased since 2000. In addition, the revolving credit facility has been used since 2001, and the amount is increasing as well.

It is better for the Abbot Group to adopt relationship banking, rather than transaction-based. Being a contractor, the Abbot Group will constantly need to borrow money from the bank, especially in the event of borrowing new loans while old ones have not been fulfilled completely. In addition, with the massive borrowing, the group needs to have a relationship bank which assesses the interest rates charged on loans or overdrafts, and makes sure the Abbot Group will receive better interest rates. By contrast, if the Abbot Group had adopted transaction banking, it would probably receive better deals in individual borrowing from different banks. However, it is doubtful (delete ‘on’)whether the borrowings will be granted on time and what interest rates the group will receive. More importantly, in the event of downturn, all these banks will line up for getting the borrowing back, rather than helping the Abbot Group to get out of trouble.

Conclusion

To summarise, the Abbot Group is maintaining its liquidity risk, as well as the relationship with its banks. However, with currency exposure, it is preferable for the group to adopt multilateral netting for internal hedging techniques, and adopt currency options for the external. In addition, the group is currently unhedged against interest rate risk, and with the current trends in its borrowing, an interest rate option is preferable.

Bibliography

Abbot Group (2002). Abbot Group Annual Report and Account 2002. Abbot Group.
Abbot Group (2001). Abbot Group Annual Report and Account 2001. Abbot Group.
Abbot Group (2000). Abbot Group Annual Report and Account 2000. Abbot Group.
Abbot Website: http://www.abbotgroup.com/
ADVFN. (2004?) Definition of Currency Risk. [Online]. Last accessed on 13th January 2005 at: http://www.advfn.com/money-words_term_1243_currency_risk.html
Atrill, P. (2002). Financial Management for Non Specialists. 2nd edition, Pearson Education Ltd.
Bank of America. (2003). The 2003 Risk Management Survey. [online]. Article from GT News.com, July 2. Last accessed on 13th January, 2005 at: http://www.gtnews.com
Bird, J. (2004). The Hedge Relationship Between Transaction and Translation Exposures. [online]. Article from GT News.com, Jan 14, Last accessed on 13th January, 2005 at: http://www.gtnews.com
Buckley, A. (2004). Multinational Finance. 5th edition, Pearson Education Ltd.
Cameron, J. (2003). A good way to do business. The Treasurer, December, p15-17.
Cowdell, P., Hyde, D. and Watson, A. (2000). Finance of International Trade. 7th edition, Financial World Publication.
Douch, N. (2002). Applying the best strategy. The Treasurer, June, p51-52.
Gamble, D. (2002). How to Manage Your Risk. The Treasurer, December, p22-25.
Gay, G.D., Kolb, R.W. and Chiang, R. (1983). Interest Rate Hedging: An Empirical Test of Alternative Strategies. The Journal of Financial Research, 6, (3), p187-197.
Hazou, P. (2004). Cashing in on banking relationships. The Treasurer, July/August, p21-22.
Hirigoyen, D. (2004). Weighing Up FX Hedging. The Treasurer, October, p19-21.
Hodges, J. (2002). Getting to know each other. The Treasurer, October, p24-25.
Knight, P. (2003). The Sins of Cash Investment. The Treasurer, June, p17-18.
Leavy, D. (2002). Setting the Framework and Getting Creative with Hedging Techniques. [online]. Article from GT News.com, March 26. Last accessed on 13th January, 2005 at: http://www.gtnews.com
Lenzer, S. (2003). Challenges of Netting. The Treasurer, September, p43-44.
Lidbark, J. (2003). Hedging Bid-to-Award Risk. [online]. Article from GT News.com, June 11. Last accessed on 13th January, 2005 at: http://www.gtnews.com
Matza, P. (2004). Building a better relationship. The Treasurer, January, p16-17.
Moclair, J. (2002). Beyond the Forward. [online]. Article from GT News.com, July 5. Last accessed on 13th January, 2005 at: http://www.gtnews.com
Ochynski, W. (2003). To Hedge or Not to Hedge? [online].. Article from GT News.com, October 27Last accessed on 13th January, 2005 at: http://www.gtnews.com
Risk Glossary. (2004?). Definition of Liquidity Risk. [online]. Last accessed on 13th January, 2005 at: http://www.riskglossary.com/articles/liquidity.htm
Shapiro, A.C. (2003). Multinational Financial Management. 7th edition, John Wiley & Sons.
Shuffrey, C. (2000). Fundamental of Multinational Netting. The Treasurer, October, p50-51.
Spottl, R. (2002). Interest-Rate Management: Fundamental Considerations. [online]. March 8. Last accessed on 13th January, 2005 at: http://www.gtnews.com
TreasuryToday (2001). The Use of Options to Manage Interest Rate Risk. Treasury Today, July/August, p8-12.
TreasuryToday. (2003). Interest Rate Hedging When Interest Rate Are Low. Treasury Today, April, p8-11.
Trenner, J. (2002). A guide to buying behaviour. The Treasurer, July/August, p31-32.
Vaswani, R. (2002). A Duty to Hedge? [online]. Article from GT News.com, March 22. Last accessed on 13th January, 2005 at: http://www.gtnews.com
Wraith, J. (2002). Your Flexible Friend? The Treasurer, May, p23-25.
--- (2003). Current Trends in Interest Rate Hedging. [online]. The Quarterly Journal of the Irish Association of Corporate Treasurers, May 7. Article from GT News.com. Last accessed on 13th January, 2005 at: http://www.gtnews.com
Charts
Chart 1: LIBOR 3-month Trends
Chart 2: UK Base Rate Trends
Chart 3: US Interest rate Trends