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Hong Kong Institute of CPAs

Financial Management Module (printed May 2010) 13 - 1

Treasury and the Financial Environment

Part A

Suggested References

When you are studying this topic we suggest the following references.

Primary References (Texts)

Ross, D.A., International Treasury Management 3rd

ed. Euromoney Books

Treasury Management Association, The Treasurer’s Handbook of Financial Management, US:

1995, Chapters 1 to 9.

Van Horne, James C., and Wachowicz, John, Financial Management and Policy, 12th Edn.

(Prentice Hall, 2002), Chapter 1.

Welch, Brian. (1999) Electronic banking and treasury security / edited by Brian Welch. (Boca

Raton, FL : CRC Press ; Cambridge : Woodhead, 1999).

Young, L.S.F. and Chiang, R.C.P., The Hong Kong Securities Industry, Hong Kong: The Hong

Kong Stock Exchange Limited, 1997. Chapters 3 to 10.

Primary References (Articles and Other)

Moonen, M.H.P. and Voorrips, G.C., “The Euro: a European Currency to Reckon With”, The

Australian Corporate Treasurer, February 1998.

Treasury Management International has articles downloadable in PDF form on Banking,

Corporate Finance, Equity Markets and many more. Many of these are free and provide a wealth

of reading material to supplement these notes:

At www.treasury-management.com. visit “TMI Magazine” and “Research”

Kiff, John and Mills, Paul, “Lessons from Sub-Prime Turbulence” (August 2007) at

http://www.imf.org/external/pubs/ft/survey/so/2007/RES0823A.htm

Section

13



Part B

Topic Learning Outcomes

Treasury and the financial environment:

• The banking and financial market

environment

• The risk framework

• The financial environment and

technology

• Sub-prime mortgage lending –

lessons learned in 2007

i) Report on the likely internal (financial) impact of actual

or proposed business strategies.

ii) Report on the likely external (financial) impact of actual

or proposed strategies and organisational decisions by:

• financial markets,

• financial market participants,

• (existing and potential) debtors, creditors and

suppliers,

• Government and regulatory bodies, etc.

iii) Comment on and interpret capital market trends.

iv) Classify risks within the financial, operational, political

and legal framework facing any organisation.

v) Identify and explain the potential impact of financial,

operational, political, legal and business risks facing an

organisation.

vi) Make recommendations about the economic impact of

external and internal events/risks on an organisation

relating to national and international factors.

vii) Identify and interpret the economic and financial

implications of the potential impact of technological

developments on an organisation.

You may choose to complete this topic in a step-by-step way or skip ahead, depending on your

knowledge and assessment of your own competency in relation to the above Learning Outcomes.

Part C

Contents of this section

13.1 Introduction ........................................................................................................................2 13.2 The banking and financial market environment .................................................................5 13.3 The risk framework ..........................................................................................................17 13.4 The financial environment and technology.......................................................................24 13.5 Sub-prime mortgage lending – lessons learned in 2007..................................................26

13.1 Introduction

Finance is concerned with risk and return attributes of assets. It can be described as the art and

science of managing money. It is broad and dynamic, dealing with the process, markets and

institutions involved in the transfer of money among and between individuals, organisations,

businesses and governments.

Financial management encompasses the duties of the financial manager in organisations which

can include budgeting, financial forecasting, cash management, credit administration, risk

management, investment analysis and funds procurement. It requires a full understanding of the

organisation’s business strategy, technology, financial markets, risks and cash flows.



The increasing degree of globalisation of business activity and evolving communication

technology (ICT) with implications for e-business have dramatically increased the challenges for

companies’ financial management, sales and investments in other countries. The need to

manage cash flows denominated in foreign currencies, to protect against political and foreign

exchange risks and multiple legal jurisdictions naturally arises from international transactions.

This makes financial management more demanding and complex.

Without a holistic understanding of the company and the financial environment, no senior

financial manager can perform the financial management function with confidence or

competence.

13.1.1 Financial Markets

Financial (capital) markets provide the means for economic entities to exchange obligations.

They interact for the purpose of buying and selling financial assets (debt and equity instruments),

allowing participants to achieve their desired portfolio mix of risk and return.

Both buyers and sellers seek to increase their wealth through this interaction. Sellers of

securities (“paper”) expect to invest the funds obtained in investment projects that increase

wealth. Purchasers of debt and equity securities expect to increase wealth, essentially through

the receipt of interest, dividends or capital growth.

Funds transfers between two parties can be classified into two types:

a) Direct - the lender and the borrower may be known to each other and the lender generally

bears the credit risk.

b) Indirect - the lender and the borrower are brought together through the use of a financial

intermediary, with the intermediary generally bearing the credit risk.

Intermediation is the process by which the flow of funds between borrowers and investors (savers)

are brought together as a result of the activities of a financial institution, such as a bank. This

financial institution is able to bring borrowers and lenders together by absorbing the credit risk.

Financial markets play both a primary and secondary role. A primary issue of a security results in

a direct flow of funds and securities between the borrower and lender. Disintermediation is the

process where companies raise funds directly from the public by issuing their own securities,

without the use of an intermediary. A secondary market then enables the securities to be traded.

The finance director and treasurer of a company are responsible for the flow of funds through

their company. Accordingly, they must be aware of the major aspects of the financial markets in

which the company operates. This awareness includes a basic understanding of how that market

evolved, its current state of development, how prices are quoted, major influences on the market

(including regulation), etc.

It is difficult for any one person to know the intricacies of all financial markets so they must also

know to whom to turn for detailed professional advice. The efficiency of the particular financial

market is important, affecting the cost of raising funds or alternatively the return they will achieve

on surplus funds (investments) of the company. The speed with which information is impounded

in market prices and the extent of any bias in prices reflects the level of market efficiency. It is

important that market participants can have confidence in the way prices are set.

While it may not be a requirement for finance directors and treasurers to understand the impact

of the emergence of city based or even national based funds into the financial markets, it would

be an advantage to visualize how the financial markets react to national funds that involve in

business transactions. An example of such is that in September 1998 the Hong Kong SAR

government used her funds to purchase the shares of the Hong Kong Stock Exchange in the

open market claiming for investment purpose, which aroused significant market reactions from

the general investors.



13.1.2 Investor Requirements

Financial managers (the treasurer) must appreciate that whilst all investors are seeking a return on their investment, the reason for purchase of the different types of “paper” will vary. This gives rise to investor types and the investment portfolio professional fund managers wish to develop.

Investors typically have a broad range of financial instruments, both domestically and internationally to choose from. These will include:

• shares

• commercial paper, bonds etc.

• derivatives

Investors seek to maximise returns in the form of either yield or growth in their assets, given their chosen risk level. Where they are seeking a yield (interest) return, they will invest in debt paper such as debentures and loan securities. They will choose government securities if they want maximum security and only are willing to lend to the corporate sector if they are prepared to accept some element of risk in order to receive a higher return (yield). An investor will look at security, maturity and flexibility of securities. The credit risk attendant with the issuer will be important. The existence of a secondary market improves the liquidity of investments, lowering risk to the holder. Recently because of international mobility concerns many international investors also purchase financial products for reasons that are not oriented from a finance perspective, which has complicated the finance manager’s concern about investor objectives.

In making an equity investment, on the other hand, the investor is demonstrably looking for something more than a fixed rate of return. An investor in shares is likely to be looking for growth in the underlying value of the investment. This may come from higher dividends or from greater capital growth.

Derivatives are initially used either by more aggressive investors wanting to assume higher leverage, or by investors wanting to hedge their exposure to their existing portfolio investments. However, with the expansion of the derivative market and the development of more complex derivative products, there is an increasing trend of integration of debt and derivative products both in terms of appearance as well as underlining asset backup. The emergence of these dual nature financial products has created more opportunities to the financial market participants, and yet also aroused tremendous problems to the world in Hong Kong since early 2008 as will be discussed and elaborated in the next chapters.

13.1.3 The Role of Leverage

Modern capital structure theory suggests that the treasurer can assist management improve shareholder wealth through the judicious use of corporate leverage; i.e. the balance between debt and equity. Management of both the financing mix and the reinvestment proportion of profit can add value to the organisation and in the case of companies increase share prices. The higher the proportion of equity finance, the better the lender’s prospects of recovering their money in a corporate failure situation. The lower the proportion of a company’s income which is committed to fixed costs and interest, the better the chance that it will be able to meet its obligations to lenders. Moderate amounts of leverage can generate significant tax shields, send positive signals to financial markets and facilitate cost efficient management structures. The costs of leverage stem largely from disruptions caused by financial distress, interest rate volatility and restrictive debt covenants. Capital market advances such as high yield bonds, securitised assets and various risk hedging instruments have mitigated many of these costs.

The treasurer needs to understand how lenders view the organisation and on what terms they have based their analysis. This serves to emphasise the importance of close banking and investor relationships. If a lender misunderstands the organisation, its management and strategy, it will adversely affect its credit rating. If the treasurer is cognisant of the organisation’s position relative to the lender, then prior to any negotiations, they will have a feel for what terms and conditions they should be able to command on pricing and documentation. This obviously strengthens the treasurer’s bargaining position.



13.1.4 The Treasurer’s Responsibilities

Directors have a fiduciary duty to their organisation, which means that they owe loyalty to it and a

duty of care to act in its best interest. They also have a responsibility to both owners e.g.,

shareholders and to investors when issuing any information such as in a prospectus. The

treasurer, as an officer of the company, is bound by laws, which reflect this requirement.

However, it is important to note that the treasurer is not regarded as a director or a substantive

officer of the corporation. Thus, the treasurer's duty of care is not as onerous as a director,

except (say) to the extent of committing commercial crimes.

13.2 The Banking and Financial Market Environment

Corporations need to have relationships with banks for a number of activities ranging from

providing debt finance, retail transaction business, financial advice and outsourcing of some

treasury activities. Other intermediaries such as stockbrokers and life insurance companies will

also be used in meeting funding requirements of the corporation.

13.2.1 The Banking Structure in Hong Kong

For a fuller understanding of the banking structure and financial markets in Hong Kong, refer to

fact sheets 1 – 10 starting at http://www.info.gov.hk/hkma/eng/public/fs99/fs01.pdf. However,

please note that some of the facts provided in the fact sheets were not updated on spot, but

rather were updated in other information sources contained in the web site of the Hong Kong

Monetary Authority at www.info.gov.hk/hkma. Bearing this in mind and making use of recent

publications in updating the data, the following is a summary of the fact sheets with updates:

Fact Sheets 1999 (with modifications and updates)

Fact Sheet 1 The HKMA's Role and Policy Objectives

The Hong Kong Monetary Authority (HKMA) was established on 1 April 1993

by merging the Office of the Exchange Fund with the Office of the

Commissioner of Banking. The functions and objectives of the HKMA are:

• to maintain currency stability, within the framework of the linked

exchange rate system, through sound management of the Exchange

Fund, monetary policy operations and other means deemed necessary;

• to promote the safety and stability of the banking system through the

regulation of banking business and the business of taking deposits, and

the supervision of authorised institutions; and

• to enhance the efficiency, integrity and development of the financial

system, particularly payment and settlement arrangements.



Fact Sheet 2 Exchange Fund and Reserves Management

The Hong Kong SAR Government’s Exchange Fund (the Fund) was

established by the Currency Ordinance of 1935 (later renamed the Exchange

Fund Ordinance) to provide backing to the banknotes issued. The Fund was

originally held in gold, silver and British pounds. In 1976, the role of the Fund

was expanded to include the management of the official reserves when the

assets of the Coinage Security Fund (which held the backing for coins issued

by the Government) and the bulk of foreign currency assets held in the

Government’s General Revenue Account were transferred to the Fund. In

addition, from 1976 onwards, the Government began to transfer its fiscal

reserves to the Fund. The Fund now holds the official reserves of Hong Kong

predominantly in foreign currency assets including cash, short-term deposits,

foreign government bonds, equities and gold.

Fact Sheet 3 The Linked Exchange Rate System

Hong Kong’s linked exchange rate system has been in effect since 17

October 1983. Under the system, the Hong Kong dollar is linked to the US

dollar at the rate of HK$7.80 to one US dollar. It has withstood a number of

tests since its inception, including the 1987 stock market crash, the June 4

event in China in 1989, the Gulf war in 1990, the collapse of the BCCI in 1991,

the ERM crisis in 1992, the Mexican currency crisis in 1994/95 and the Asian

financial turmoil in 1997/98. In the face of these shocks, the Hong Kong dollar

exchange rate has remained remarkably stable.

The HKMA introduced a strong-side Convertibility Undertaking to buy US

dollars from licensed banks at 7.75, and announced the shifting of the existing

weak-side Convertibility Undertaking from 7.80 to 7.85

With the increasing trend of exchange rate inflation between the Renminbi

(RMB) and the US dollar since 2005, and the recent deterioration of the US

economy due to the Sub-prime Mortgage Crisis and the “Capital Tsunami” in

2008, there is continuous guessing and speculation on the possible

abandonment of the linked exchange rate system between the Hong Kong

dollar and the US dollar, or a change of the pegged exchange rate thereof.

But the Financial Secretary of the Hong Kong SAR has repeatedly stated that

the linked exchange rate system will not be abandoned or modified. This is

despite the fact the RMB has been inflating against the Hong Kong dollar,

which has affected the price of imported goods from China and the general

inflation rate of Hong Kong. Coupled with this has been the weakening of the

US dollar in the first half of 2008 when most foreign currencies rose to the

historic high against the US dollar.

Disregarding the political consequence of any change in the linked exchange

rate system, there are controversial opinions among economists and finance

experts whether it is good or otherwise to Hong Kong at this moment to

abandon or modify the said rate system. With the capital tsunami starting in

the third quarter of 2008 and the general depression experienced by all parts

of the world now, most economists and financial experts also expressed

uncertainty on the movement of the Hong Kong dollar rate should its pegged

exchange rate be abandoned.



Fact Sheet 4 Debt Market Development in Hong Kong In the course of the last decade, the

Hong Kong Monetary Authority (HKMA) has taken a number of steps to

develop the infrastructure and assist in the growth of the debt market in Hong

Kong. These measures have included:

• the introduction of the Exchange Fund Bills and Notes Programme;

• the creation of a benchmark yield curve extending to 10 years;

• the establishment of an efficient central clearing and custodian system

for debt securities (the Central Moneymarkets Unit - the CMU) and

linking it to Euroclear, Cedel and other central securities depositories in

the Asian Pacific region;

• the granting of profits tax exemption/concession for qualifying debt

securities;

• the extending of the market making system for Exchange Fund paper to

debt securities established by statutory corporations;

• the use of Exchange Fund paper as margin collateral for trading in

stock options and futures;

• the listing and trading of Exchange Fund Notes on the Stock Exchange

of Hong Kong;

• the implementation of the Real Time Gross Settlement (RTGS) System;

and

• the establishment of the Hong Kong Mortgage Corporation.

Fact Sheet 5 Real Time Gross Settlement System

Hong Kong’s interbank payment system entered a new era on 9 December

1996 with the launch of the Real Time Gross Settlement (RTGS) system by

the Hong Kong Monetary Authority (HKMA) and the Hong Kong Association of

Banks (HKAB). The new system is one of the HKMA’s major initiatives to

enhance the robustness of the financial infrastructure and the competitiveness

of Hong Kong as an international financial centre. It is one of the most

advanced interbank payment systems in the Asia Pacific region.

Fact Sheet 6 Hong Kong Mortgage Corporation

The Hong Kong Mortgage Corporation Limited (HKMC) was incorporated in

March 1997 with the mission of developing Hong Kong’s secondary mortgage

market. The HKMC is a public limited company, wholly owned by the

Government through the Exchange Fund, and incorporated under the

Companies Ordinance. The HKMC’s business is being developed in two

phases. The first phase involves the purchase of mortgage loans for its own

portfolio, funding the purchases largely through the issuance of unsecured

debt securities. In the second phase, the HKMC will securitise the mortgages

into mortgage-backed securities (MBS) and offer them for sale to investors.



Fact Sheet 7 Banking Policy and Supervision

Hong Kong maintains a three-tier system of deposit-taking institutions, namely,

licensed banks, restricted licence banks and deposit-taking companies. They

are collectively known as authorised institutions (AIs) under the Banking

Ordinance. Only licensed banks may operate current and savings accounts,

and accept deposits of any size and maturity.

Restricted licence banks are principally engaged in merchant banking and

capital market activities. A restricted licence bank may take time, call or notice

deposits from members of the public in amounts of HK$500,000

(approximately US$64,103) and above without restriction on maturity.

Deposit-taking companies are mostly owned by, or otherwise associated with,

banks. They engage in a range of specialised activities, including consumer

finance and securities business. These companies may take deposits of

HK$100,000 (approximately US$12,821) or above with an original term to

maturity of at least three months.

Hong Kong has one of the highest concentrations of banking institutions in the

world. At the end of December 2006, there were 138 licensed banks, 31

restricted licence banks and 33 deposit-taking companies operating in Hong

Kong. These 202 authorized institutions operate a comprehensive network of

1,313 local branches. Of these 202 authorized institutions, 181 were

beneficially owned by interests from 30 countries. Despite this, however,

general investors and the public may not have comprehensive information

about the banking industry in Hong Kong, and it is perceived that less than 30

licensed banks are generally recognized by the public.

The authorisation criteria for licensed banks, restricted licence banks and

deposit-taking companies seek to ensure that only fit and proper institutions

are entrusted with public deposits. The Hong Kong Monetary Authority (HKMA)

conducts periodic reviews of the authorisation criteria and, when necessary,

introduces amendments to reflect the changing needs of the regulatory

environment and to meet new international standards.

It should be noted that in October 2008 the Hong Kong SAR Government has

announced a policy of 100% guarantee without to all bank deposits put to the

licensed banks in Hong Kong. This was to protect the Hong Kong banking

system from collapse because of the “capital tsunami” and the bankruptcy of

numerous banks in the US and other countries, which triggered the loss of

confidence by general depositors to the banking system. The guarantee will

be in force until 2010 and then it will be subject to review depending on the

progress or possible recovery of the world economy from the “capital tsunami”.

Fact Sheet 8 Banknotes and Coins

The Government, through the Hong Kong Monetary Authority (HKMA), has

given authorisation to three commercial banks, the HSBC, the Standard

Chartered Bank and the Bank of China, to issue currency notes in Hong Kong

(Chart 1). Authorisation is accompanied by a set of terms and conditions

agreed between the Government and the three note-issuing banks.

Banknotes are issued by the three banks, or redeemed, against payment to,

or from, the Government’s Exchange Fund in US dollars, at a specified rate of

US$1 to HK$7.80 under the linked exchange rate system. Banknotes issued

by the three commercial banks are printed in Hong Kong by Hong Kong Note

Printing Limited (HKNPL).



Fact Sheet 9 Hong Kong's Monetary System and the 'One Country, Two Systems' Principle

Under the principle of ‘one country, two systems’ enshrined in the Sino-British

Joint Declaration and the Basic Law (Annexes 1 & 2), Hong Kong enjoys a

high degree of autonomy except in foreign affairs and defence matters. In

particular, Hong Kong’s monetary system remains separate from that of the

Mainland of China, and the Government of the Hong Kong Special

Administrative Region (HKSAR) formulates its own monetary and financial

policies. The Hong Kong dollar, as the only legal tender in the HKSAR,

remains freely convertible. The free flow of capital within, into and out of the

HKSAR is guaranteed and no exchange control policies may be applied in

Hong Kong. The Hong Kong dollar continues to circulate as a freely

convertible currency, and the authority to issue Hong Kong currency is vested

in the HKSAR Government. Hong Kong’s foreign exchange reserves, held in

the Exchange Fund, are managed and controlled by the Government of the

HKSAR primarily for regulating the exchange value of the Hong Kong dollar.

Fact Sheet 10 Hong Kong as an International Financial Centre

Hong Kong is one of the world’s major financial centres. It has achieved this

position through its strategic geographical location, a liberal economic policy,

the free flow of capital and information, a diligent workforce, a sound legal

system, a low tax rate, and an efficient physical infrastructure. Banking is the

linchpin of financial activities in Hong Kong. Around 60% of banking business

is denominated in foreign currencies (including Renminbi). As at end of

October 2007, the Hong Kong Stock Exchange was ranked number 5 in terms

of market capitalization, just behind the US, UK, Tokyo and Shanghai Stock

Exchanges.

13.2.2 Cash Management in Hong Kong

Corporate treasurers seek to:

• accelerate receivables;

• maximise returns on surplus funds;

• reduce transaction costs;

• reduce foreign exchange risks;

• reduce taxation risks; and

• minimise borrowing costs.

Hong Kong’s payment system entered a new era on 9 December 1996 with the launch of the

Real Time Gross Settlements System (RTGS) by the Hong Kong Monetary Authority (HKMA) and

the Hong Kong Association of Banks (HKAB). The system is one of the HKMA’s major initiatives

to enhance the robustness of the financial infrastructure and competitiveness of Hong Kong as an

international financial centre. It is one of the most advanced interbank payment systems in the

Asia Pacific region.

Since the implementation of the RTGS system in 1996, the Hong Kong Monetary Authority

(HKMA) developed and implemented the Delivery versus Payment (DvP) facilities for share

transactions in 1998, having built an interface between the RTGS system and the clearing and

settlement system for shares operated by Hong Kong Clearing. The RTGS system has also

provided the building block for Payment versus Payment (PvP) for US dollar exchange

transactions in 2000.



The HKMA has also reached agreement in principle with the People’s Bank of China (PBOC) to

establish a PvP link between the Hong Kong’s Hong Kong dollar payment system and China’s

National Automated Payment System (CNAPS) when CNAPS goes live. A PvP link will reduce

the settlement risk in foreign exchange transactions arising from the difference in timing in the

final settlement of the two currencies involved.

The RTGS and its subsequently developed Delivery versus Payment (DvP) and Payment versus

Payment (PvP) systems have enabled the finance people to manage their cash portfolios in a

more efficient way, notably in the reduction of settlement risks between cash as well as share

transactions. Before the implementation of RTGS and DvP, there was often a realization or

delayed settlement risk for treasurers and financial controllers to hold short term funds in form of

marketable securities and foreign currency. The existence of such realization risk imposed

certain restrictions to the treasurers in managing cash and short terms finds, especially when the

funds could be suddenly called upon for immediate use at any time. The RTGS uplifted these

worries and treasurers are now more comfortable in choosing various fund portfolios. When the

RTGS links with CNAPS while foreign exchange control is still exercised in the Mainland China,

Hong Kong will then act as an “offshore” exchange centre for overseas corporations to handle

business transactions with Chinese business organizations. Accountants and treasurers could

make use of this potential benefit in the foreseeable future to execute global fund management

related to China businesses.

The RTGS may also be relevant to corporations that are “wired” to their banks, customers and

suppliers with the following 3 advantages: (1) records keeping and routine transactions are easy

to automate, (2) marginal costs of transactions will be lower, and (3) float is drastically reduced.

An extensive range of fundamental cash management accounts and services are offered by

Hong Kong’s principal banks, including local and foreign currency current accounts, savings

accounts and time deposit accounts.

For further information and related links to RTGS, please refer to the following web site:

http://www.info.gov.hk/hkma/eng/infra/index.htm

13.2.3 Financial Markets in Hong Kong

Hong Kong’s geographic position, which provides a bridge in the time gap between North

America and Europe, strong links to China and other economies in South East Asia, and

excellent communications with the rest of the world have helped the territory to evolve into an

important international financial centre.

In recent years, the market has experienced a reorientation from an equity focus to encompass a

wide range of debt, equity linked and derivative instruments as financial market participants

become more sophisticated and borrowers and investors demand more mature, diverse and

flexible products. Hong Kong’s unrestricted regulatory environment allows local, regional and

global investors access to a broad range of currencies and instruments.

Surveillance of the financial market is exercised by the Securities and Futures Commission (SFC)

established in 1989. It exercises prudent supervision over:

• the securities;

• financial investment; and

• commodities futures industries.

Its detailed regulatory framework brings Hong Kong into line with international standards of

market regulation and practice. Until September 2008, the SFC has performed its monitoring

duties satisfactorily as perceived by both the financial participants and the community in general.

However, with the break out of the capital tsunami, SFC, HKMA and other government agencies

have been subject to severe criticism on the non-monitoring of the high risk derivative products in

particular the Mini-Bonds issued by Lehman Brothers as well as other financial products related

to this once globally praised bankrupted investment banker.



As a result of the Mini-Bond incidence in Hong Kong and the financial tsunami which happened

around the world, the financial market of Hong Kong has become stagnant in the fourth quarter of

2008, with sales of any financial products nearly coming to a total halt. Investors in Hong Kong

have temporarily lost trust in the financial market and the issuers of bonds and other financial

products which might have once been regarded as low risk instruments. Fortunately the financial

market in particular the stock market in Hong Kong had gradually recovered since the beginning

of the second quarter in 2009. Although the bond market is not yet recovered in domain, the

general atmosphere of the financial market is not as bad as some pessimistic analysts might

have predicted..

In order to lead Hong Kong recovery from the current economic depression due to the financial

tsunami, the SAR Government at the initiative of the Chief Executive, formed an Economic Task

Force in October 2008 with 10 members from different disciplines. The aim of the Task Force is

to seek solutions to the crisis or even grasp the opportunities available to Hong Kong in taking

advantage of the situation. Throughout the year 2009 the Task Force had held several meetings

and proposed some recovery actions for the restoration of the financial market in Hong Kong.

a) The Hong Kong Stock Market

The Hong Kong equity market is one of the most actively traded in Asia. Due to the HK$ being

pegged to the US$, the Hong Kong stock market is highly sensitive to US interest rates. Its

broadest measure is the Hang Seng Index (HSI) which is a market capitalisation weighted index,

which, in November 2008, counted the 42 largest stocks as its constituents. The market is

gaining liquidity in hybrid debt and equity products as borrowers are increasingly looking to reduce

their cost of capital using these products.

Starting early 2007, there is also a notable sign that the Hong Kong stock market is also

increasingly affected by the economic development of the Chinese Mainland and the stock

market performance of Shanghai and Shenzhen. It has been observed numerous times that the

Hong Kong stock market follows the trend of the Mainland market despite the US stock market

turns in the other way round. In the earlier period it had been observed that the price of A shares

in the Chinese Mainland doubles that of the H shares in Hong Kong for some corporation that is

listed both in Hong Kong (the H shares) and the Mainland (the A shares). With more state owned

corporations who “returned” to China and issued A shares, the price discrepancies between A

and H shares have been getting closer since the second half of 2007. Thus the financial

managers have to take note of the movements of both China and US markets now in judging the

performance trend of the Hong Kong stock market.

It should be noted that with reference to the Efficient Market Hypothesis and based on researches

done on other stock exchanges such as the NYSE, Hong Kong would best be regarded a semi-

strong market if not a weakly efficient market. Thus the stock price movements of the shares

listed on the Hong Kong Stock Exchange might be subject to many moderating factors and do not

necessarily represent the economic performance and fundamental value of business

corporations. The fluctuating stock price movements of Hong Kong listed shares throughout

2009 serve as a good indicator of this. When the Hong Kong stock market is considered as one

of the possible factors for financial decisions, this issue should be borne in mind.

b) The Hong Kong Debt Market

Hong Kong’s fixed income (debt) market is only a fraction of the global debt market, mainly due to

the absence of government debt. The Hong Kong government in the past operated an enviable

surplus and as such was no need for debt markets as they exist in many Western economies.

Even utility companies are relatively debt free. However, the Hong Kong Government has

announced plans to launch debt in its 2004/5 budget and subsequently issued bonds in 2004 to

finance her budget deficits.



For Asian companies equity is still the most convenient and efficient option of financing business

and there is little enthusiasm for corporations to switch to debt. One of the major problems in the

development of the debt market is the lack of secondary trading, resulting in a lack of liquidity to

attract substantial numbers of debt investors. Debt investors seek liquid markets in case they

wish to liquidate their investment (with or without capital loss). Initiatives are being undertaken by

the Hong Kong Monetary Authority (HKMA) to develop liquidity in Hong Kong debt markets.

In Hong Kong, the government in its own right does not issue any "Treasury Bills" or "Government

Bonds" at present (although the government had once issued government bonds in the 1980s).

The government issued bonds amounting to $20 billion, which was completed in July 2004,

including the first time issue of US$1.25 billion 10-year institutional notes to institutional investors)

However the HKMA has issued "Exchange Fund" bills and notes which are similar to Treasury

Bills and Bonds. The Exchange Fund Bills are issued with maturity ranges from 2 years to 15

years. This initiative is helping to develop liquidity in the debt markets in Hong Kong.

The following tables summarise the offered interest rates in respect of Exchange Fund Notes

from 2 year to 10 year maturities for the period encompassing first quarter 2009 to fourth quarter

2009. Note that these tables reflect a fluctuating sloping yield curve in 2009, reflecting the

unstable global financial situation after the outbreak of the capital tsunami.

Summary Interest Tables for Exchange Fund Notes issued by the HKMA

Source: HKMA - "Yield of Exchange Fund Bills and Notes", Monthly Statistical Bulletin.

1 Qtr / 2009 2 Qtr / 2009 3 Qtr / 2009 4 Qtr / 2009

2 Year 0.77 0.71 0.49 0.41

3 Year 1.12 1.32 0.90 0.88

5 Year 1.59 2.19 1.71 1.69

7 Year 1.81 2.62 2.11 2.14

10 Year 1.93 2.87 2.36 2.37

c) The Foreign Exchange Market

The HK$ has pegged to the US$ at the rate of HK$7.80 equals US$1 since 1983. This eliminates

the exchange rate factor as a variable in the territory’s economic development and stability.

Interest rates rise and fall in line with movements in interest rates in the US except in the last

quarter of 2004 to preserve the currency peg and the money demand and supply. The HKMA is

responsible for exercising effective influence over liquidity and interest rates in the HK$ market.

As a foreign exchange centre, Hong Kong is increasingly geared towards serving the needs of

Greater China, leaving Singapore to concentrate on South East Asia.

d) Derivatives Markets

Hong Kong has an active exchange traded and over-the-counter equity derivatives market and a

developing debt derivatives market. Equity and debt derivative products such as forwards and

swaps, as well as exotic options are traded on the over-the-counter market. Contracts are made

on a bilateral basis, with terms negotiated separately for each transaction.

Hong Kong also has a highly developed derivative warrants market. According to the HKMA

Supervision of Markets Division, in 2004 and 2005 Hong Kong’s derivative warrants market was

the most active market in the world. The market has been growing rapidly in recent years. The

average daily turnover rose by 6 times during 2002-2005. During the first quarter of 2006, the

average daily turnover of derivative warrants in Hong Kong was HK$6.1 bn (US$780 mn), 75%

higher than the 2005 level. As trading activities on the stock market as a whole also surged over

the period, the share of derivative warrants in the total market turnover remained stable at about

19%.



In particular, the growth in trading activities was driven by the trading of derivative warrants issued

on Mainland stocks. For instance, the trading of derivative warrants issued on the top three

Mainland stocks, namely China Life Insurance, China Construction Bank and China Mobile,

surged by some 90% during the first quarter of 2006 from the second half of 2005 (the growth for

the whole derivative warrants market was about 50%). The strong interest in Mainland securities

was also reflected in the trading of H shares which soared 83% whilst the turnover of the total

market turnover increased 58% over the same period. However, the global financial crisis has

resulted in a reduction of derivatives trading activity in 2008 and 2009.

In 2006, there were about 18 active derivative warrants issuers in Hong Kong and most were

international investment banks. They provide a critical mass of expertise in the market, which is

able to develop a wide range of derivative warrants to meet different risk appetites of different

investors.

Market Infrastructure

Hong Kong has a well-developed market infrastructure. The political environment is relatively

stable, and its macro-economy demonstrated general resilience from the Asian financial crisis of

the late 1990s. As a Special Administrative Region (SAR) of the People’s Republic of China

(PRC), Hong Kong is also linked closely with the increasing integration of the PRC in the global

economy. Hong Kong’s banking system is sophisticated and well supervised, and the

government rarely intervenes in the market or protects individual sectors.

Moreover, access to public exchanges is relatively high. Hong Kong has also made

improvements to the required informational infrastructure in recent years. Local accounting

standards are being harmonised with international standards. Transparency and disclosure is a

focus of the Hong Kong Institute of Certified Public Accountants (HKICPA), the Securities and

Futures Commission (SFC), the Stock Exchange of Hong Kong, and the Companies Registry.

Gaps can still be identified, however, with regard to the content of annual and interim reports,

operational analysis, and executive remuneration. The regulatory framework is well established,

encouraging good practices and providing a supportive environment. One criticism, though,

frequently voiced by local market observers is that the regulatory powers of investigation and their

ability to enforce regulations fall short of some more pro-active regimes.

As mentioned above, the debt and derivative market in Hong Kong has been closed to a

complete halt since the Lehman Brothers and the Mini-Bond incidence. How long it would take

before the derivative market could be re-operated as usual is the question to which no person

could provide a concrete answer as at this moment.

Source: Ian Byrne. The Year of Corporate Governance p.3.

Retrieved from www.treasury-management.com. Treasury Networks 2003.

Example 1: Treasury Issues in Financing a Company

Required

a) What key issues must a financial manager (treasurer) understand when considering the

financing of a company?

b) How are these financing decisions affected in the Hong Kong Market? Is the debt market

growing? Comment on the depth of the market and pertinent institutional factors.



Suggested Solution

Example 1: Treasury Issues in Financing a company

a) A financial manager must understand, as a minimum when financing the company:

• the company’s activities and cash flows,

• the operation of banking and financial markets,

• investor requirements,

• financial market efficiency,

• the role of leverage,

• the financial manager’s (treasurer’s) responsibilities when operating in financial

markets, and

• to whom to turn for professional advice.

b) The Hong Kong market does not have the liquidity in the debt market as developed

markets in Western countries. Accordingly there are differences in:

• the operation of banking and financial markets,

• investor requirements,

• financial market efficiency,

• the role of leverage,

• professional advice, and

• the size of the debt market.

e) Commercial Paper

In the global money market, commercial paper is an unsecured promissory note with a fixed

maturity of 1 to 270 days. Commercial Paper is a money-market security issued (sold) by large

banks and corporations to get money to meet short term debt obligations (for example, payroll),

and is only backed by an issuing bank or corporation's promise to pay the face amount on the

maturity date specified on the note. Since it is not backed by collateral, only firms with excellent

credit ratings from a recognized rating agency will be able to sell their commercial paper at a

reasonable price. The use of commercial paper is therefore restricted to a comparatively small

number of large companies.

Commercial paper is usually sold at a discount from face value, and carries shorter repayment

dates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the

issuing organisation must pay. Interest rates fluctuate with market conditions, but are typically

lower than banks' rates.

Businesses may purchase commercial paper as an investment medium for excess cash, or may

issue commercial paper when seeking additional cash. One potential problem with commercial

paper is that it is an impersonal relationship between two organisations, and financial advice or

support if one party is in trouble is unlikely (in contrast to borrowing from a bank).



Example 2: Cost of Commercial Paper

Sound Products Ltd issues $1 million of 30-day commercial paper at an interest rate of 7.5% pa.

The total transactions fee, including the cost of a backup credit line, on using commercial paper is

0.25% of the amount of the issue.

Required

Estimate the cost of the issue?

Suggested Solution

Example 2: Cost of Commercial Paper

Interest = 0.075 x $1,000,000 x 1/12 $ 6,250

Transaction fee = 0.0025 x $1,000,000 2,500

Total $ 8,750

13.2.4 Recent Developments in Hong Kong Financial Markets

The development that has had the most impact on Hong Kong financial markets in 2008 and

2009 has been the global financial crisis. However, the Hong Kong financial system remains solid.

In his review in the 2008 Annual Report, the CEO of the HKMA stated; “That Hong Kong has

come through so far with its monetary system intact and its financial system still robust is due, in

no small part, to the actions that we have taken, not just during the crisis itself but also over many

years, to prepare for unforseen events.”

In spite of the financial crisis, there have been a number of positive developments over the last

few years.

Market Development

Bond Market

To facilitate the development of a Hong Kong dollar bond market, in 2004 the FSTB encouraged

public corporations to issue bonds, to explore new channels for distribution of bonds, to provide

necessary financial infrastructure, to simplify the issuance process, to offer tax incentives and to

continue investor education. The Hong Kong Government also contributed funds to the Asian

Bond Fund established by regional governments to stimulate local currency bond markets. This

had a number of implications for treasury management and the financial environment in Hong

Kong, including:

• The determination of interest rates, yield curves and the setting of short term interest

rates.

• The concept of default risk and how default risk affects interest rate and how it could

change over time.

• The definition and issuance of bonds. Ordinary debenture bonds, collateralized bonds etc.

Features such as call feature, redemption feature and convertibility feature; their effect on

the bond’s effective interest rate; the sinking fund, different types of sinking funds and the

effect of sinking funds on the equilibrium market interest rate on the bonds.



• Valuation of bonds, yield to maturity, yield to call, current and capital gains yields.

• Accounting for bonds under US GAAP.

• Rating of corporate and country bonds by S&P and Moody’s.

• Determination of capital structure – the equity/debt mix, the pecking order hypothesis,

private and public (bond and stock) issues, floatation costs.

• Retirement of bonds and repurchase of stocks, the direct and signalling effects on the

value of the firm.

All these topics will become more relevant and more meaningful after the development of bond

market in Hong Kong, and detailed discussion of them will be deferred until the market develops

fully.

Regulatory Framework

With the Lehman Brothers incidence, the FSTB is now under pressure in determining how to

amend and make tougher rules in respect to the securities and company legislation based on the

comments of all stakeholders and the review carried out by SFC and other government agencies.

It is expected that the regulatory amendments will impose many stringent controls over the issue

of derivative products and the responsibilities of issuers as well as selling agents and guarantors

as it has been experienced under the Sarbanes Oxley Act in the US after the Enron incidence in

2001.

Fund Management

The FSTB has issued a consultation paper regarding the proposal to exempt offshore funds from

profits tax. It will also work with overseas regulators to allow international funds easier access to

Hong Kong investors.

Banking

The implementation of the scheme for providing personal RMB business by banks in Hong Kong

will be the main focus of FSTB in this area. The aim is to facilitate RMB fund flows between the

Mainland and Hong Kong through the banking system. The Legislative Council of Hong Kong

SAR has passed the Banking (Amendment) Ordinance in July 2005, which gives effect to amend

the Banking Ordinance to provide for the introduction of the revised banking supervision

standards modelled on “Basel II").

Market Infrastructure

The FSTB is preparing new legislation to provide a formal regulatory regime in respect of clearing

and settlement systems which will bring the Hong Kong dollar into the international Continuous

Linked Settlement (CLS) System - a global system for clearing and settling cross-border foreign

exchange transactions.

In addition to these policy initiatives the FSTB has issued a consultation paper on proposals to

enhance the regulation of listing. The proposals involve giving certain listing requirements

statutory backing and finding ways to improve the regulatory structure governing the performance

of the listing functions.



13.2.5 The Banking Environment of the Chinese Mainland

In the Chinese Mainland the banking industry is regulated by the China Banking Regulatory

Commission (CBRC). The main functions of CBRC include the following:

a) Formulate supervisory rules and regulations governing the banking institutions,

b) Authorize the establishment, changes, termination and business scope of the banking

institutions,

c) Conduct on site examination and off site surveillance of the banking institutions, and take

enforcement actions against rule breaking behaviours,

d) Conduct fit and proper tests on the senior managerial personnel of the banking

institutions,

e) Compile and publish statistics and reports of the overall banking industry in accordance

with relevant regulations,

f) Provide proposals on the resolution of problem deposit-taking industry in accordance with

relevant regulations,

g) Responsible for the administration of the supervisory boards of the major State-owned

banking institutions, and other functions delegated by the State Council.

Unlike the Hong Kong situation, the foreign currency policies and exchange is under the authority

of the State Administration of Foreign Exchange (SAFE) instead of CBRC. The SAFE submits

proposals to the central government for the settlement of foreign exchange rate of RMB as well

as to regulate the foreign exchange policies and rules for RMB and other foreign country

monetary units. In the Mainland, there are still tight foreign exchange controls, and both inward

and outward remittance of foreign exchange is subject to severe regulations under different

situations. For example, an individual in the Chinese Mainland may not be able to remit an

equivalent amount of US$2,000 or more in each year without the prior approval of the SAFE.

Corporate investors such as the Qualified Foreign Institutional Investors (QFII) are also subject to

controls in remitting profits in securities investment back to their home based countries. Thus, the

foreign exchange transactions of the banking industry in the Chinese Mainland will be subject to

both the general regulations of the CBRC and the specific regulations of the SAFE.

With the honoring of the WTO commitment in December 2006, the banking industry is going to

fully opened in the Chinese Mainland to overseas financial institutions, subject to the

requirements that overseas financial institutions have to meet before allowing to performing

banking operations in the Chinese Mainland. For the details of the Regulations on the

Administration of Foreign Banks issued by CBRC which became effective on 11 December 2006,

see the web site at: http://www.cbrc.gov.cn/english/home/jsp/docView.jsp?docID=2871

As the Mainland banking system is still under transition from tight state controlled to market

regulations, whenever the banking operations are required, special attention and care should be

taken to ensure that all the complicated regulations instituted by various departments have been

compiled with. Otherwise it will cause much trouble to the business organizations involved.

13.3 The Risk Framework

Financial management requires a full understanding of total risk to a business. A holistic

approach to all risks faced by a business must be adopted. This requires an understanding of:

• Risk assessment: what can go wrong?

• Risk control: what can we do about it?

• Risk financing: how do we pay for it?



Hazard risks Business risks

Management must be aware that risk is a dynamic rather than static concept. Risk management

requires imagination and innovation, especially in risk financing. The effects of managing or

mismanaging risk will have an effect on the finances of a company. The process of risk

management must also be a mechanism for coping with the effects of a changing environment.

Historically it has tended to lag change.

The figure below provides an illustration of the ways in which risk exposures may arise. The

diagram is divided into four quadrant showing different types of risks. These exposures need to

be mitigated through control and failures to do this means the risk must be financed.

Source: Managing Risk; Trends and Techniques for Challenging Times, April 1991.

It must be understood that there is no economic benefit to be derived from waiting until risk

strikes! Accordingly, the treasurer must understand the potential effects of risks on the cash

flows and financing of the company.

Financial/ market

Operational

Securities

Criminal

Date

Personnel

Regulations Product liability

State action Tort liability

Contracts

Statutory liability

Controls Controls

Controls Controls

Terrorism

Commodities

Currency

Interest rate

Consequential

Physical damage

Credit

Financing

Legal Political



13.3.1 Organisational Risk Strategy and Management

The topic of risk management and the finance and treasury function is discussed in Section 15.

The purpose of the following discussion is to highlight a few key points in relation to

organisational risk strategy and management:

a) Risk management must happen at three levels within the business:

i) Strategic level: risks derived from external sources. These are primarily the

responsibility of the Board of Directors.

ii) Operational level: risks derived from the processes. These are primarily the

responsibility of process owners, but risk management solutions must be shared

with the rest of the organisation.

iii) Co-ordination: to bring strategic and operational risks together as a synchronised

activity. This is the primary responsibility of a “risk champion/manager”.

b) The shift in perspective required to move the business towards a proactive and pre-

emptive approach to the management requires a fundamental change.

c) To make things happen there needs to be a conscious effort led from the top through the

involvement of people who can command credibility throughout the organisation.

d) The critical contribution of the risk management function is to facilitate four-way

communication between the Board of Directors, business units, business risks and

management process owners.

e) Commitment of permanent resources to the risk management function will ensure that

the process is continuous.

f) Managing risk in the business must continue to be the prerogative and obligation of line

management.

g) Management reporting needs to:

i) Ensure activity is aligned with and fulfils the business strategy.

ii) Provide data and analysis as a basis for decision making.

iii) Measure performance.

iv) Confirm control and compliance.

The risk management process must develop a process that identifies all risks and their potential

impact on the finances of the company. A company must complete a risk audit on an ongoing

basis. This requires an understanding of:

a) Risk assessment: what can go wrong?

b) Risk control: what can we do about it?

c) Risk financing: how do we pay for it?

13.3.2 The Role of Treasury and Financial Market Risks

Risk, in business, is the possibility that an organisation’s operations will deteriorate, and that

future results will be worse than predicted or expected. Companies face two broad types of risk:

business risk and financial risk.

Business risk arises when a company’s commercial activities and operations are less successful

than in the past or as expected. For example, sales turnover might fall because a competitor

undercuts the company’s prices, or introduces a rival product. It is well recognised that the

function of management is to meet the challenges of business risk and bring successful products

and services to the market in an efficient and effective way.



Financial risk is perhaps less understood. It is the risk that financial conditions could be either

less favourable than expected, or could change, causing business positions in financial terms, to

deteriorate. Financial conditions relate to money and debts, such as the cost of borrowing, the

yield from investments, the availability of money to borrow and customer bad debts. All of these

events may have an adverse effect on the cash flows of a company and affect the profitability and

solvency objectives of the company.

The three major areas of treasury management can be summarised as:

a) Liquidity (working capital management)

A fundamental responsibility of treasury is the measuring, monitoring and managing of

cash flow and liquidity to safeguard the solvency of the entity. Cash flow forecasting is a

fundamental requirement of responsible financial management. Working capital

management is covered in Section 16 “Short Term Financing and Working Capital

Management”.

b) Funding (long-term corporate finance)

An optimal mix of equity supported by short-term and longer-term financing facilities can

meet the funding of the entity’s operation and capital expenditures and investments.

There are advantages if the use of funds can be matched in maturity and conditions with

those of the sources of finance. As an example, seasonal fluctuations in working capital

could be financed by bank overdraft.

An essential role of treasury is to establish and maintain good relations with banks

providing finance and with credit agencies, where a good credit rating will enhance the

prospects of borrowing in domestic or international capital markets. International capital

markets may give rise to foreign exchange exposure.

c) Financial risk

The extent to which treasury needs to be involved in risk management will vary according

to the nature, size and complexity of the business and the availability of experienced staff.

To ensure that decision making activity is both efficient and prudent, treasury must have

a combination of clear policy (including risk limits within which it can operate), and

resources to perform the functions, together with operational flexibility to respond quickly

to changes in the well-informed and fast-moving financial markets.

Treasury must be established under strict guidance and written policy approved by the

Board of Directors.

13.3.3 Financial Risk Categories

Financial risk categories managed by the treasury operation can be broken down into a number

of forms:

a) liquidity risk

b) funding risk

c) interest rate risk

d) commodity price risk

e) operational risk (business risk)

f) foreign exchange risk

g) credit risk



a) Liquidity Risk

Liquidity risk can be defined as the risk of having insufficient cash resources to meet day-to-day

obligations, or take advantage of profitable opportunities when they arise.

Liquidity, as a part of cash management, is the ability to obtain:

• the right amount of funds

• at the right price

• in the right currency

• in the right time zone

• at the right cost

• at the right time

Liquidity risk, in an overall sense, is the risk that the company will not have sufficient financial

resources to meet its liabilities (creditors and debts) as they fall due. This may include the risk

that borrowed funds may not be available when the company requires them or they will not be

available for the required term or at an acceptable cost.

There is also the risk that borrowers may lose credit lines from banks if they fail to comply with

loan covenants. The company may have to maintain adequate unused funding sources

(generally at a cost) in view of such factors as future debt repayments, capital expenditure,

seasonal fluctuations, potential acquisitions and contingencies. Funding sources may include

equity issues (in all forms), debt, supplier finance and leasing.

Three forms of liquidity risk can be recognised:

• Day-to-day cash management - ensures funds are available when needed.

• Short-term liquidity crisis management - management of liquid assets and stand-by

facilities.

• Long-term going concern liquidity management - ongoing processes of ensuring funding

facilities are available to meet future long-term requirements.

Liquidity risk will be broken down in Section 16 “Short Term Financing and Working Capital

Management” under the headings “Working Capital Management” and “Cash Flow and Funds

Management”.

b) Funding Risk

Funding risk is a subset of liquidity risk. It is the ability to raise funds, at an acceptable cost, at

the right time.

c) Interest Rate Risk

Interest rate risk is the risk that movements in interest rates will affect financial performance

(profit) by increasing interest expense or reduce interest income, depending on its movement in

an upward or downward direction.

Interest rate volatility has substantially increased interest rate risk since the deregulation of

financial systems around the world since the 1980s. A company needs to be aware of the impact

on its Income Statement and cash flow for a given change in interest rates. Proper management

of this risk by treasury can add to the profitability of the company.



d) Commodity Price Risk

Commodity price risk is the risk that a change in the price of a commodity that is a key input or

output of a company will adversely affect its financial performance. Often commodity prices have

a foreign currency component in their pricing and this amplifies the risk to the company. The

approach to managing commodity price risk is similar to the management of foreign exchange

risk.

e) Operational Risk

Operational risk is the risk of financial loss arising from the operational activities of the treasury

function. This risk is the inherent risk of operating a treasury function and would therefore be

common to all organisations with treasury activities and a treasury function. The risk arises from

specific areas including staffing, information systems, security and the physical environment.

Operational risk is generally associated with reliance on internal and external systems relevant to

the monitoring, negotiating and delivery of financial transactions. The risks are wide ranging and

can include natural disasters, human errors, breakdown of financial systems or failure of

electronic systems.

Such risks can place stress on the cash flows of a company and must be understood by the

corporate treasurer.

f) Foreign Exchange Risk

Foreign exchange risk is the risk that the rate of exchange used to convert foreign currency

revenues, expenses, cash flows, assets or liabilities to the home currency will move in a direction

that causes profitability and/or net shareholder wealth to decline.

There are three types of foreign exchange risk:

• transaction risk - resulting from normal operational business activities of converting

foreign currency receipts or payments into the home currency;

• translation risk - resulting from the conversion of long-term foreign currency assets and

liabilities into the home currency at regular intervals for statutory reporting reasons

(annual balance sheet);

• economic risk - created by taking a different approach to managing foreign exchange

exposures from that of the company’s competitors. Even companies which have no

international business are exposed to exchange rate risk because their domestic markets

could switch to a foreign supplier if their product was cheaper.

In Hong Kong, foreign exchange risks faced by financial people are often magnified by the

possible de-linking of the pegged exchange rate system between Hong Kong dollars and the US

dollars. It is even suggested by some analysts that a decision on such is no longer totally

controlled in the hands of the Hong Kong SAR government, but it has become part of the total

foreign exchange policy of the whole country of China.

Because the central government of China increasingly uses interest rate policy to monitor

economic development pace of China, and the continuing negotiations between China and the

US in exchange rate parity, Hong Kong at present faces foreign exchange risks both between

Hong Kong dollars and RMB, as well as with other overseas countries given the exchange rate

fluctuations between China and the US.



g) Credit Risk

Credit risk is the risk that the other party to a financial transaction will not meet their financial

obligations on time (or at all). Delayed payments from customers also provide a cash flow

deficiency and incur a cost, since money that is still owed ought to be cash in the bank, either

reducing a bank overdraft or earning interest on deposit. This substantially affects the profitability

and solvency objective of a company.

There are three key categories of credit risk:

• Counterparty risk is the risk that the other party to a financial transaction will not meet its

obligations as to timing or amount of settlement.

• Country risk can be divided into political risk, regulatory risk and economic risk. It is

generally beyond the direct control of the counterparty.

- Political risk is associated with government directives and policies that may affect

the (financial) contractual performance of either party to the transaction or create

continuing uncertainty about what the government might do.

- Regulatory risk is the risk that regulations affecting financial conditions will be

introduced, or that existing regulations will be enforced more severely than in the

past.

- Economic risk is the risk that economic conditions within a country will have

harmful financial consequences, particularly for inflation, interest rates and

foreign exchange rates. If a government were to decide, for example, to

increase public spending by borrowing heavily, business opportunities would

arise for suppliers and contractors to the government, but the financial

consequences of a larger Public Sector Borrowing Requirement might be much

higher interest rates for commercial and private borrowers. This could restrict

the ability of debtors to pay.

• Settlement or delivery risk is the risk that there is default in a single settlement or delivery.

Example 3: Corporate Risk Management

Required

a) What are the key headings for a corporate risk framework and what are the key

questions that must be answered?

b) What does an integrated organisation-wide system of risk management attempt to

achieve?

c) Risk can be managed through a process of avoidance, transfer, control and retention.

Provide an example.

d) What is the role of the treasurer in risk management?

Suggested Solution

Example 3: Corporate Risk Management

a) What are the key headings for a corporate risk framework and what are the key

questions that must be answered?

• Focusing on risk.

• Why focus on risk?



• A risk management framework.

• What is the business case for developing a risk management framework?

• How should a framework be developed?

• The identification of risk.

• What process might a company consider using for the identification of risk?

• The measurement of risk.

• What measures of risk are appropriate?

• Management solutions.

• How might the risks be managed?

• Risk reporting and organisation.

• How could they be reported?

• The way forward; the role of the treasurer.

• Who is responsible for managing risk?

b) What does an integrated organisation-wide system of risk management attempt to

achieve?

• Align management activity explicitly with corporate objectives.

• Reduce volatility of performance.

• Prompt investment in business, which delivers greater reward for a given amount

of risk.

• Increase the efficiency of the business.

• Create added value for shareholders.

• Demonstrate compliance with regulatory requirements.

• Provide a springboard for growth, born out of greater confidence about outcomes.

c) Risk can be managed through a process of avoidance, transfer, control and retention.

Provide an example.

• Avoidance (withdraw from the industry).

• Transfer (performance bonds in financial markets or insurance for pure risk).

• Control (sprinkler systems in buildings).

• Retention (a situation where the company is capable of financing it, should

adverse events occur).

d) What is the role of the treasurer in risk management?

• To enhance the quality of business cash flows by the better management of risk.

13.4 The Financial Environment and Technology

Information exchanged between organisations in the operation of commerce includes requests

for quotes, bids, purchase orders, order confirmations, shipping documents, invoices, remittance

advices and payments. The two usually fall under the responsibility of the treasurer. This

requires an understanding of Electronic Commerce (ECOM) and Electronic Data Interchange

(EDI).



From your reading about services provided in the financial markets in Hong Kong, you can see

that this is already an issue. The issue is even more problematic in the situation of the Mainland

because of both the information filtering process as well as the exchange control mechanism

operated by the Central Government, even though China has recently fully open its banking

system in honouring the WTO Agreements.

Dealing with information exchanges with trading partners, ECOM impacts all areas of a company:

• marketing;

• production;

• transportation;

• purchasing; and

• finance.

Banks also provide ECOM services, especially where they are critical for banking relations and

providing services. ECOM also changes cash flow time lines and therefore the level of current

assets and working capital. When companies implement electronic payments, the typical cash

management problem of collections, disbursements and concentration change considerably

bringing both benefits and disadvantages.

13.4.1 Technology and the Finance Function

Technology has impacted greatly on the development of integrated packages that allow the

finance function to interface internally within the company and externally with financial (and other)

markets and others. Integrated computer packages now allow the dealing room to interface with

confirmations and settlement, accounting, cash management and treasury management areas,

internally and external to the company. Technology covers wide range areas of finance and

accounting. Technology has allowed the development of global views by bringing a vast array of

functions together through the use of technology and communications. The treasurer must be

aware of these issues.

13.4.2 The Internet

The Internet is a source of a wide range of information about financial markets and treasury. For

a corporate treasurer, the Internet links professional finance and treasury bodies together. They

provide real time (or near real time) financial information including movements in currency and

interest rates, as well as forums for discussion on important financial and treasury issues on a

real time basis.

The Finance and Treasury Association in Australia links the worldwide web of professional

treasury bodies together (Internet address http://www.asct.com.au). Other Internet sites of

interest are included in the list of primary references. The treasury Internet link has been

designed to assist members access information for treasury professionals on the Internet.

Summary

Because most business decisions are measured in financial terms, the financial manager plays a

key role in the operation of the firm. Financial management, however, is more than just

understanding financial fundamentals.

Internally, financial managers require a full understanding of the company and events and risks

that will impact on its cash flows. As a result of these events and risks, the financial manager

must have an understanding of how to solve financial problems, not only in ensuring that the

company has sufficient funds to remain in business in an every day sense, but also to be able to

gain funds to fund expansion. This requires an in-depth understanding of finance.



Finance is affected and influenced by financial markets, legal requirements, political issues and

information. The financial manager must have a broad understanding of all these issues with

knowledge of to whom to turn to for specialist advice.

The pace of technological change appears to be increasing. As well as understanding the impact

of these changes on financial markets, the financial manager must be prepared to use

technology to gain information. The use of the Internet is increasing and the financial manager

must be aware of its advantages.

13.5 Sub-Prime Mortgage Lending – Lessons Learned in 2007

Source: Kiff, John and Mills, Paul, “Lessons from Sub-Prime Turbulence” (August 2007) at

http://www.imf.org/external/pubs/ft/survey/so/2007/RES0823A.htm

Please also refer to investment research reports issued by UBS and the Hong Kong Property

Market Report by JP Morgan (www.morganmarkets.com) in October and November 2008

respectively

Sub-prime mortgages are residential loans that do not conform to the criteria for “prime”

mortgages, and so have a lower expected probability of full repayment. This assessment is

usually made according to the borrower's credit record and score, debt service-to-income (DTI)

ratio and, in some cases, the mortgage loan-to-value (LTV) ratio.

Recent sub-prime lending growth in the USA was boosted by more highly leveraged lending

against rapidly rising house prices. However, by 2005-06 higher DTI and LTV ratios were

insufficient to close the housing affordability gap for many sub-prime borrowers, so lenders

started to offer “affordability” products. These included “hybrid” and “option” adjustable-rate

mortgages (ARMs) that require payments at low initial fixed “teaser” rates - which can result in

negative amortization during the first few years.

As long as house prices were rising, the rate reset shocks that occurred when the teaser rates

expired could be averted by refinancing the mortgage into another hybrid or option ARM. But

many lenders and borrowers knew, or should have known, that such loans were not viable at the

full interest rate.

As house price appreciation decelerated in 2006, delinquencies and defaults on sub-prime

mortgages originated in 2006 soared, despite favourable economic conditions. While house

prices were rising, distressed borrowers had the equity to renegotiate their loans or could sell

their homes and repay their mortgages.

However, slowing house price appreciation in 2006-2007 and rising interest rates left many

stretched borrowers with no choice but to default. The highest delinquency rates have been

associated with hybrid and option ARMs, particularly those that involved risk “layering” - high LTV

loans to high DTI borrowers with little income verification.

The speed with which delinquency and default rates have risen for loans originating in 2006 has

been striking. The first sign of trouble was the high volume of "early payment defaults," (EPDs) in

which the borrower misses one or two of the first three monthly payments, which has been

followed by rising delinquency rates. Fraud also appears to have played a key role in accelerating

the deterioration, which resulted in the failure of a number of originators in 2006-07 as

securitizers exercised “put-back” options - forcing lenders to take back delinquent mortgages.



Lessons learned

Kiff and Mills have outlined lessons to be learned from the sub-prime incident in the United States.

These lessons should be applied to the housing mortgage market in Hong Kong. Kiff and Mills

identify the following lessons.

Investors have placed excessive trust in rating agencies' approaches to structured credit. The

ratings methodology for corporate credit risk is fundamentally different from that used for

structured credit and yet the ratings that result are placed on the same scale, implying similar

potential losses. To avoid future confusion, ratings for the different types of obligation should be

clearly distinguished and investors should never just rely on ratings to determine investment

policy.

Looking ahead, the combination of interest rate resets are likely to create significant payment

shocks for borrowers in 2007-09. In the recent past, sub-prime borrowers were able to limit

payment resets by refinancing. However, with lending standards tightening and house equity

falling, this will now be significantly harder. Hence, imminent payment resets mean that defaults

on riskier U.S. mortgages are likely to continue rising in the short- to medium term.

So what can policymakers do to avoid a similar crisis in the future?

Improve consumer protection. With lending standards tightening, the appropriate policy response

needs to balance improving consumer protection with maintaining the viability of the securitisation

model that has successfully dispersed credit risk away from systemically important financial

institutions. This is a challenging task within a regulatory and legal framework ill-suited to provide

effective consumer protection against predatory lending in an originate-to-securitise financial

model. Securitisers have access to relevant information over loan quality and one option could be

to assign (capped) liability to them if checks against fraud and predatory lending in the pools of

loans securitized are inadequate. Losses should be dispersed to exposed investors rather than

taken over by taxpayers if borrowers cannot be assisted through loan modifications

Tighten oversight. Federal banking regulators have recently tightened guidance on non-traditional

and hybrid ARM mortgage lending. However, the fragmented nature of U.S. financial regulation

means that observance and enforcement of such standards is not uniform. The five regulators

can enforce compliance by their regulated institutions but, since non-bank lenders and loan

brokers are regulated at the state level, such initiatives also rely on consistent state-level

enactment and enforcement. The U.S. Federal Reserve is reviewing its powers to regulate

mortgage transactions and tighter restrictions, especially concerning the clarity of disclosures to

borrowers and the availability of the riskiest loans, appear warranted.

Resist pressure for bailouts. Policymakers will face continuing pressure to bail-out or subsidise

stretched sub-prime borrowers. However, such pressures generally should be resisted due to the

danger of reinforcing speculative or fraudulent behaviour - losses should be dispersed to exposed

investors rather than taken over by taxpayers if borrowers cannot be assisted through loan

modifications.



Recent information on sub-prime implications for Hong Kong and Mainland. For more recent

information on the likely implications of the sub-prime incident for Hong Kong and Mainland China,

refer to the February 2008 issue of “A Plus” the Hong Kong Institute of CPAs monthly journal. In

this issue, John Ryan observes that the threat to China that worries accounting professionals is

twofold. First, Chinese banks and other financial institutions are already finding themselves

among the many investors stuck holding billions of dollars of difficult-to-understand AAA-rated

debt that has suddenly become toxically illiquid and accordingly difficult to price. The second,

more likely threat, is that the US mortgage crisis will send the world’s largest economy into a

recession and crimp sales of manufactured exports that many regard as the key factor sustaining

China’s economic growth. In fact, many corollary effects have begun to emerge in Hong Kong

since October 2008 as many local organizations in the banking and finance, manufacturing and

notably the entertainment industries started to dismiss staff and cut down the organisation size in

order to improve cash flow liquidity and achieve a strong position to survive the crisis. The prime

function of the treasurer in every corporation is to withhold and source as much cash resources

as possible in these days to ensure that the corporation will not be distressed or even bankrupt

because of insolvency, until banks are willing to loosen their lending policies again.

Part D

Practice Question 1 [20 Marks]

Fine Furnishings (Hong Kong) Limited (FFHK) is a company that manufactures a wide range of

high quality wooden furniture in its two factories in the New Territories. It was founded by the

present managing director ten years ago and over the past ten years has enjoyed a period of

unbroken growth in sales and profitability. Despite the recent recession the company has

continued to grow and has been able to maintain its profit margins at very attractive levels.

Furthermore the market values of both properties owned by the company have increased slightly

in spite of the recession.

The board of directors believe that as the economy moves out of recession the opportunities for

further growth in sales and profitability will continue to increase. To meet these new opportunities

the company has recently been reorganised. The business has adopted a more decentralised

management structure and has committed itself to becoming a “world class manufacturer” of

modern and traditional furniture. As part of this commitment the management of the company

have recently implemented a total quality management programme.

The directors of the company are aware that their objectives cannot be achieved without major

investment in new machinery and equipment. The company’s internal resources are likely to be

inadequate to provide the finance necessary to take all of the potentially profitable opportunities

available to the business. The board has accepted the need to raise a substantial amount of

finance for new investments and believes that this is essential if the company is to achieve its

stated objective of a Stock Exchange Listing within the next five years. The company’s managing

director is conscious of the fact that the somewhat ad hoc approach to raising finance used by

the business in the past is not going to be acceptable in the future. In consequence the first item

on the agenda for the next board meeting is the formulation of a financing strategy for FFHK.

The company’s managing director is very aware of his limited knowledge of the workings of the

financial markets. He has been advised that if FFHK is to develop a coherent financing strategy

he must understand the nature and role of the financial markets in Hong Kong and further that he

must understand the characteristics of the relationships between lenders and borrowers as well

as those between investors and the businesses they invest in. He wants to do some “homework”

before the next board meeting and has asked you as his long-standing financial advisor to

provide him with some background information to help him cope with the issues currently facing

his business.



Required

Provide a draft report for the managing director which:

a) Explains the nature and role of the financial markets. [6 marks]

b) Considers the relationships between lenders and borrowers as well as

that between investors and the businesses they invest in. [4 marks]

c) Describes the main components of the financial markets in Hong Kong

and the securities traded on those markets. [5 marks]

d) As part of requirement c) complete the boxes in the tables below. [5 marks]

[Total: 20 marks]

The securities traded on Hong Kong’s equity and debt markets are as follows:

Instrument Primary

market

Secondary

market

Comments

Money market

Commercial paper Yes No Primary market activity is

dominant.

Promissory notes

Exchange fund bills

Bond markets

Exchange Fund Notes

Corporate bonds

Certificates of deposit

Non resident issues

Equity

Shares

Foreign currency

Instruments

Dragon bonds

Corporate bonds



Hong Kong derivative products are listed below:

Products Active

Market?

Comments

Interest rate

Forward rate agreements (FRAs) Yes Reasonably active market; still developing.

Futures

Swaps

Options

Caps/collars

Equity

Futures

Options/warrants

Suggested Solution


Timing (minutes) Part a) 9

b) 6

c) & d) 15

Total time spent on question: 30 minutes

a) The Nature and Role of the Financial Markets.

Financial (capital) markets provide the means for economic entities to exchange obligations.

They interact for the purpose of buying and selling financial assets (debt and equity instruments).

There are two categories of the transfers of funds between parties:

1. Direct - the lender and the borrower may be known to each other and the lender generally

bears the credit risk.

2. Indirect - the lender and the borrower are brought together through the use of a financial

intermediary, with the intermediary generally bearing the credit risk.

Intermediation is the process by which the flow of funds between borrowers and investors (savers)

are brought together as a result of the activities of a financial institution, such as a bank. This

financial institution is able to bring borrowers and lenders together by absorbing the credit risk.

Disintermediation is the process where companies raise funds directly from the public by issuing

their own securities, without the use of an intermediary.



Additional Information about the Role of Financial Intermediaries

There are a number of different types of financial intermediary and they all have different

functions in the efficient working of the financial markets e.g.:

Commercial banks

• Cheque payment and clearing system

• Receive deposits from small investors

• Lend short term and medium term to companies (and individuals)

Merchant banks

• Lend medium and long term to companies

• Provide financing and investment advice

• Organise share issues (including underwriting)

• Advice and representation on takeovers and mergers, etc

Finance companies

• Finance houses: hire purchase and instalment credit

• Leasing companies

• Factoring companies

Insurance companies

• Collect insurance premiums

• Invest long term in debt and equity

• Debt lending can be to smaller firms, but equity investment is normally listed shares.

Pension funds

• Collect savings from employees

• Invest long term in debt and equity, as insurance companies. (Not good practice to invest

in the organisation for which the employees work)

Unit trusts

• Trust funds which invest in a portfolio of listed equity shares

• Each investor holds ‘units’ which represent a proportion of the fund

• Market value of fund is directly related to market values of underlying investments

• Advantage: spreads small investor’s risk (portfolio effect) cheaply

Investment trusts

• Quoted limited companies which invest in the shares of other companies.

• Advantage: as for unit trusts.

• Market value of investment trust’s shares is not necessarily easily related to value of

underlying investments.



Financial intermediaries serve three important purposes in the working of the financial markets

1. Aggregation (collect together small deposits - can lend large amounts)

2. Maturity transformation (collect short term deposits - can lend long term)

3. Risk reduction (can reduce risk cheaply for small investors by investing in a portfolio of

equity shares which they could not afford to own individually).

Financial markets play both a primary and secondary role. A primary issue of a security results in

a direct flow of funds and securities between the borrower and lender. A secondary market then

enables the securities to be traded.

b) Business: Investor Relationships

Investors make their investment in a company by buying the company’s securities. Generally the

securities offered by a company are in three forms:

• Shares

• Commercial paper, bonds etc.

• Derivatives

Companies and corporate financial managers must be aware that whilst all investors are seeking

a return on their investment, the reason for purchase of the different types of “paper” will vary.

This results in different investor types and consequent differences in the investment portfolios

professional fund managers wish to develop.

Investors in non-equity securities will be concerned with security, maturity and flexibility.

Investors will look at the credit risk of the company in order to satisfy themselves that the funds

will be repaid on the due date. The maturity of the security i.e. the date for repayment will also

affect the investors willingness to invest. If only long-term investments are available, the investor

will wish to be sure of the existence of a secondary market. A well functioning secondary market

provides the flexibility investors require by enabling them to trade the securities they have bought

in order to realise the funds invested.

Equity investors on the other hand, are looking for more than security and a fixed rate of return.

They seek a return on their investment, which comprises dividends and capital growth. On many

stock exchanges the dividend yield on ordinary shares is very low so it is apparent that the

primary objective of most equity investors is capital growth.

c) Financial Markets in Hong Kong

Hong Kong’s capital markets are among the most sophisticated in Asia. Hong Kong has:

• The largest stock market in Asia, outside of Japan;

• Foreign exchange turnover amongst the highest in the world;

• An emerging debt market; and

• A derivatives market.

In recent years, the market has experienced a reorientation from an equity focus to encompass a

wide range of debt, equity linked and derivative instruments as financial market participants

become more sophisticated and borrowers and investors demand more mature, diverse and

flexible products.



The Hong Kong stock market

The Hong Kong equity market is one of the most actively traded in Asia. Due to the HK$ being

pegged to the US$, the Hong Kong stock market is highly sensitive to US interest rates. Its

broadest measure is the Hang Seng Index (HSI).

The Hong Kong debt market

Hong Kong’s fixed income (debt) market is growing. However, for Asian companies equity is still

the cheapest and most efficient option of financing business and there is little enthusiasm for

companies to switch to debt. One of the major problems in the development of the debt market is

the lack of secondary trading, resulting in a lack of liquidity to attract substantial numbers of debt

investors. Debt investors seek liquid markets in case they wish to liquidate their investment (with

or without capital loss). Initiatives are being undertaken by the Hong Kong Monetary Authority to

develop liquidity in Hong Kong debt markets.

The securities traded on Hong Kong’s equity and debt markets are as follows:

Instrument Primary market Secondary market Comments

Money market

Commercial paper Yes No Primary market activity is

dominant.

Promissory notes Yes Yes Stable primary market: limited

secondary trading.

Exchange fund bills Yes Yes Strong, active secondary market

Bond markets

Exchange Fund Notes Yes Yes Active and developing market:

maturities largely out to three

years.

Corporate bonds Yes No Small, but developing market.

Certificates of deposit Yes Yes Low activity; maturities usually

exceed one year.

Non resident issues Yes No Small; developing market;

inaugural issues 1989.

Equity

Shares Yes Yes Well-established active market,

but with only a small market for

listed foreign company shares.

Foreign currency

Instruments

Dragon bonds Yes No Emerging market

Corporate bonds Yes Yes Small; market growing (especially

convertibles)

Source: Hong Kong Stock Exchange



The Foreign Exchange Market

The HK$ has pegged to the US$ at the rate of HK$7.80 equals US$1 since 1983. This eliminates

the exchange rate factor as a variable in the territory’s economic development and stability

although from time to time speculations on the possible de-linking of the pegged exchange rate

system distort the market to a greater or lesser extent. Interest rates rise and fall in line with

movements in interest rates in the US, to preserve the currency peg and the money demand and

supply. The HKMA is responsible for exercising effective influence over liquidity and interest

rates in the HK$ market.

As a foreign exchange centre, Hong Kong is increasingly geared towards serving the needs of

Greater China, leaving Singapore to concentrate on South East Asia.

Derivatives Markets

Hong Kong has an active exchange traded and over-the-counter equity derivatives market and a

developing debt derivatives market. Equity and debt derivative products such as forwards and

swaps, as well as exotic options are traded on the over-the-counter market. Contracts are made

on a bilateral basis, with terms negotiated separately for each transaction.

Hong Kong derivative products are listed below:

Products Active

Market?

Comments

Interest rate

Forward rate agreements (FRAs)

Yes Reasonably active market; still developing.

Futures No HIBOR futures contract not active

Swaps Yes Small developing market; maturity lengthening.

Options Yes Reasonably active market

Caps/collars Yes Reasonably active market

Equity Futures Yes Active market.

Options/warrants Yes Options on stock and warrants written by financial institutions, and warrants issued by listed companies traded.




Liquidity risk is an essential component of the risks that Treasury needs to manage and should

be covered in a formal policy. It is important to appreciate that not all individuals will assess risk

the same way. The timing of borrowing and the structuring of the borrowing terms will depend on

forecasts and an assessment of how likely they are. Not all financial analysts will have the same

attitude toward risk.

There are many psychometric profiling tools available to assess risk. Below is a reduced form

questionnaire which may provide a clue to attitude towards risk. It should not be used as a

serious tool. (You may wish to search on the web under personal risk assessment to find more

commercial instruments)

Yes that’s me

A bit like me

Not really me

Not Me

1 I generally prefer familiar situations

2 I generally give in when my plans conflict with those of family and friends

3 If offered a choice of a performance related end of year bonus each year of $40,000 or a salary increase of $20,000 I would take the salary increase.

4 I have confidence in my ability to overcome mistakes

5 If I had to choose a comfortable life or an exciting one I would choose the comfortable one.

6 I often put off making financial decisions because I am concerned I may make a mistake

7 I can handle big losses and disappointments without difficulty.

8 I believe that opportunity only knocks once.

9 If I received a $500,000 inheritance I would invest in shares

10 If I received a $500,000 inheritance I would invest in fixed interest securities.

Scoring

Questions 1, 2, 5, 6, 8, 10 score from left column to right column as 1, 2, 3, 4 respectively

Questions 3, 4, 7, 9 score from the left to the right as 4, 3, 2, 1 respectively.

Result ranges:

30-40 less risk averse than most people

20-29 mid range

10-19 risk averse



Required

a) Complete the risk profiling questionnaire and compute your score. Ask a colleague

whom you intuitively feel may be different to you, in attitude toward risk, to complete the

questionnaire. Tally up the score. Were you correct in your assessment of their being a

difference?

b) Suppose a company could borrow money for six months from the bank at 9% pa, i.e.

4.5% for six months or it could borrow on a 5 year term loan at an interest rate of 8.3% pa.

Which is best?

c) Do you think that a risk averse person and a non-risk averse person would make the

same decision as to whether to hedge interest rate risks?

Suggested Solution



b) 10

c) 10


a) There is often a wide range of attitudes towards risk among people which is part of the

risk tapestry of life. There is no definite answer as to how differing risk assessments will

influence attitudes toward financing but they do point to the need for clear policies to

ensure that decisions are not made on purely personal whims.

b) While the long-term interest rate is lower than the short-term interest rate, these rates

refer to quite different time horizons. If you need continuing finance and borrow short,

you will know your interest rate for six months but then be faced with borrowing again at

the then prevailing interest rate. In the short-term the short-term loan is better but in the

longer-term the answer depends on what you expect the future to hold. Considerations

include, among others, future financing needs, likely interest rates, any restrictions on

credit availability, strength of balance sheet and earnings/cash flow streams likely in the

future.

c) It is not possible to be definitive but generally we would expect risk averse people to

hedge. The same is true with insurance in that the risk taker is more likely to self insure

than pay a premium to transfer the risk to someone else.

Practice Question 3 [15 marks]

Refer to Section 13.2.3 of this CLP. Find the table titled; “Summary Interest Tables for Exchange

Fund Notes issued by the HKMA”.

Required

Answer briefly, the following questions in relation to this table:

a) What do you observe about the relationship between interest rates and maturity?

b) What is the name given to this phenomenon?

c) What determines the shape of this phenomenon?

d) Why is knowledge of this important to company financial treasurers and investors?

e) Why had the two year interest rate on Exchange Fund Notes fallen to 0.76% during the

fourth quarter of 2008?



Suggested Solution

Practice Question 3 [15 marks]


b) 4

c) 6

d) 4

e) 4


a) As the maturity period increases, the yield to maturity increases also.

b) The phenomenon is known as the “term structure of interest rates”. It results in a “yield

curve”, which in this case is seen to be upward sloping. Historically, in most years long-

term rates have been above short-term rates, and this results in the upward sloping yield

curve observed here. For this reason, financial experts often call an upward sloping yield

curve a “normal yield curve”. But it is possible for an abnormal downward sloping yield

curve to occur. This happened in the early 1980s, when short term interest rates were

abnormally high.

c) The shape of the yield curve depends upon two factors; one, expectations about future

inflation and interest rates and; two, perceptions about the relative riskiness of securities

with different maturities.

Some experts argue that the second factor – relative maturities – is considerably less

important than expectations about future rates. They contend that the market is

dominated by large traders who buy and sell securities of different maturities each day,

that they focus only on short-term returns, and that they are less concerned with risk.

This argument has been called the pure expectations theory of the term structure of

interest rates.

However, a majority of experts would argue that risks associated with interest rates do

matter, and that the market regards long-term securities as riskier than short-term ones.

This view is often called the liquidity preference theory.

d) Knowledge of the term structure of interest rates is important to company financial

treasurers, because they must decide whether to borrow by issuing short-term or long-

term debt. It is also important to investors, who must decide whether to buy short-term or

long-term fixed-interest securities.

e) By the end of the fourth quarter of 2008 short term interest rates had fallen to very low

levels. This reflected the actions of central monetary authorities around the world. This

dramatic fall in interest rates was triggered by the actions of the Federal Reserve in the

United States and was followed by many other jurisdictions around the world, including

the Hong Kong Monetary Authority.



Part E

How do I know I have succeeded in this topic?

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Report on the likely internal (financial) impact of actual or proposed business strategies.

Report on the likely external (financial) impact of actual or proposed strategies and organisational decisions by:

• financial markets,

• financial market participants,

• (existing and potential) debtors, creditors and suppliers,

• Government and regulatory bodies, etc.

Comment on and interpret capital market trends.

Classify risks within the financial, operational, political and legal framework facing any organisation.

Identify and explain the potential impact of financial, operational, political, legal and business risks facing an organisation.

Make recommendations about the economic impact of external and internal events/risks on an organisation relating to national and international factors.

Identify and interpret the economic and financial implications of the potential impact of technological developments on an organisation.

treasury and the section 13 - hkicpa.org.hk · treasury and the financial environment: ......

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