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Sdertrns hgskola Fretagsekonomiska enheten Bachelor Thesis in Finance

Spring 2001

Treasury Management
- The case of CGE&Y -

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

Clarhll & Lillerud

Treasury Management - the case of CGE&Y

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

Clarhll & Lillerud

Treasury Management - the case of CGE&Y

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

Clarhll & Lillerud

Treasury Management - the case of CGE&Y

Contents
1 INTRODUCTION ....................................................................................................................................... 6 1.1 THESIS OUTLINE ........................................................................................................................................ 6 1.2 BACKGROUND ........................................................................................................................................... 6 1.2.1 The company CGE&Y ..................................................................................................................... 6 1.2.2 The bank situation in the Nordic region of CGE&Y ....................................................................... 7
1.2.2.1 1.2.2.2 Transfer deadlines..................................................................................................................................... 10 Hedging foreign payments and receivables .............................................................................................. 11

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

THEORY.................................................................................................................................................... 20 3.1 THEORETICAL FRAME OF REFERENCE ...................................................................................................... 20 3.1.1 The law of one price ...................................................................................................................... 20
3.1.1.1 3.1.1.2 3.1.1.3 3.1.1.4 Interest rate parity ..................................................................................................................................... 21 The international Fisher relation............................................................................................................... 21 Relative purchasing power parity ............................................................................................................. 22 Unbiased forward expectations................................................................................................................. 22 Which way should one go?....................................................................................................................... 23 Covered interest arbitrage in practice ....................................................................................................... 23 Currency risk management ....................................................................................................................... 24

3.1.2 3.1.3 3.2 3.3 3.4 4

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

3.1.2.1 3.1.2.2 3.1.3.1

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

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

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Treasury Management - the case of CGE&Y

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

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

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Treasury Management - the case of CGE&Y

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

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

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

Clarhll & Lillerud

Treasury Management - the case of CGE&Y

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

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

Figure 1; CGE&Ys bank relations

To employ a single bank is one part of CGE&Ys plans to set up a new finance center situated in the headquarters of the Nordic region in Alvik Strand, Stockholm. The purpose of the finance center is an effective management of all short-term financial investments of excess cash, which is a part of Treasury Management. This will be made possible through the new
1 2

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

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Treasury Management - the case of CGE&Y

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

Sweden

CGE&Y AB

Telecom

NIS

CGE&Y Sweden joint bank account in SEK

CGE&Y Denmarks account in SEK

CGE&Y Finlands account in SEK

SSC

CGE&Y Norways account in SEK

Figure 2; The Swedish CGE&Y bank account structure

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

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

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Treasury Management - the case of CGE&Y

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

Figure 3; Joint bank accounts in the Nordic region

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

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

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Treasury Management - the case of CGE&Y

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

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

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

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

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

Every company is interested in maximizing its profits in the longer perspective. This is because the company is obligated to satisfy its shareholders in the long run. This can be done
8 9

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

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

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

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

10 11

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

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1.3.3

Definition of excess cash

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

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

1.5

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

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

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1.6

Limitations

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

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2 Method
Before starting working on a thesis we had stated two goals for ourselves. The first one was the ambition to write the thesis in English. This ambition origin in the belief that it would be an instructive challenge and that it might be worthwhile in the future to have a thesis in an international language. After all, we are studying International Business. The second goal was that we should get in contact with a company to be able to get an assignment that is directly related to reality. We believed it would be more fun, challenging and meaningful knowing, or at least hoping, that someone would be able to use whatever facts we were to conclude. We got in contact with CGE&Y through a contact we know who is employed by the company. The reason for choosing CGE&Y was that we think it is an interesting company that operates internationally and that very well could be a future employer to us. Another reason is that we managed to intercept CGE&Y while still in the process of developing a finance center. Through the company we got introduced to the subject Treasury Management. Previously we had merely touched the subject in one of our courses, International Finance. CGE&Y wanted help investigating the problem stated previously. After reviewing and correcting the assignment to meet the demands from our advisor we started off by reading literature to learn about the subject Treasury Management and its functions as a whole. We used the Universitys library database to search for related literature. We ordered literature through the library, which we had got recommended from professors and researchers of financial business and economics. We soon realized that it is a huge subject that contains, among other parts, both borrowing and lending of short money for an organization. In the process of getting deepened into the subject we also searched the Internet for old theses and working papers. The database on the Swedish school of Economics was useful in finding relevant working papers. There were several previous working papers that had conducted research on related subjects, but not too much on our specific case. It was hard to find specific literature and information about the subject in the beginning. But we found literature or working papers that investigated our specific problem. The literature contained facts about the capital market parities and related implications of it. However we never found any investigations similar to ours. Continuing contact and interviews with our advisor and our contact person on CGE&Y meant a lot to make sure that we were going in the right direction. We interviewed Gabriel Oxenstierna, Ph.D. of economics at Sdertrns hgskola, to get a good overview of the banking aspects. He also recommended some literature and a few Internet sites. As the work progressed it became clear that we were to use a qualitative method. The subject is to complex to enable standardized surveys to provide information that would be of value to us. We needed to do deepened interviews. We also concluded that we were working with a hypothesis in a manner that is similar to an analytical inductive method17. This means that we collected data relevant to our problem and after that we started analyzing the collected data. When we dug deeper into the subject an experimental calculation model started to take form. At first we were thinking of a calculation model that were to take into account the different interest rates between the countries plus a number of other macro factors. We were considering CGE&Ys possibilities to make arbitrage business, so the model that we were
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Frn datainsamling till rapport- att gra en statistisk underskning, p. 241

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

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

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

18 19

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

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2.3

The interviews

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

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

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

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

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

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

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

=
Expected change in spot rates

Relative purchasing power parity

=
Unbiased forward expectations

E(Std / f ) / S0d / f

Figure 4; Capital market equilibrium- the international parity conditions

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

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Figure 424 summons the implications of the law of one price, where i = nominal interest rate, d = domestic, f = foreign, t = time, E= expected, = inflation, F = forward rate, S = spot rate. These are the mutual relations that actively interact in the international capital markets. Together these relationships always strive the market back towards equilibrium in case any discrepancies should arise. Interest rate parity is the only actual- as distinct from expectedrates in figure 4. This relation is the closest and best documented of the relationships. 3.1.1.1 Interest rate parity Interest rate parity implies that the forward premium or discount between two currencies is determined by the nominal interest rate differential between those currencies for the period. The formula for interest rate parity is: Ftd / f/S0d / f = (1+id)t/(1+if)t. A forward premium or discount on the left hand side of the equation reflects the interest rate differential on the right hand side. Because each price in the equation is actively traded, the interest rate parity always holds within the bounds of transaction costs in the currency markets.25 Interest rate parity is essential for the main purpose of this thesis. According to Butler26 the interest rate parity is the only of the four relationships in the capital market equilibrium one can trust at all times, both in the short and long run. 3.1.1.2 The international Fisher relation The Fisher equation, also referred to as the Fisher effect, states that nominal interest rates are related to real interest rates and inflation rates according to: (1 + i) = (1 + r)(1 + ), where i = nominal interest rate, r = real interest rates and = inflation rates. If one solves this equation for the nominal interest rate one get: i = r + + r. According to Butler, its quite usual to approximate the nominal interest rate by adding the real interest rate to the inflation rate. But this approximation is only recommended when interest and inflation rates are low. Otherwise the margin of errors increases. The formula for the international Fisher relation, or the international Fisher effect, is; (1 + id)t / (1 + if)t = (1 + d)t / (1 + f)t. However, it is important to note that in this equation represents expected inflation and that the relationship therefore requires a forecast of the future rate of inflation. And, as also should be noted, forecasting the future is never an easy task. If the law of one price holds for real rates of returns in two different countries, then this would imply that rd = rf and that the interest rate differentials reflect inflation rate differentials according to the Fisher equation. In practice, this would mean that real interest rates across countries are the same, and that the only variable that constitutes the difference in nominal interest rates is the difference in inflation rates across countries. However, studies based on historical real interest rates and inflation rates lend some support to the international Fisher relation but they also prove that it doesnt always hold in the short run. The relation between inflation and nominal interest rates is poor. According to Butler, real interest rates are not equal across currencies and they fluctuate over time as well. But it does exist equilibrium for real interest rates. Investors are attracted to investment opportunities in currencies with high real returns. This will automatically drive currency prices upward and at the same time push the perceived yields downward together with the real interest rates. This mechanism restores
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Multinational Finance, p. 99 Multinational Finance, p. 90-93, Multinational Business Finance, p. 122-127, Currency Risk and Business Management, p. 25 26 Author of Multinational Finance

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

Covered interest arbitrage is sometimes referred to as free lunch. As can be understood from the reasoning above interest rate parity states that if the parity conditions hold, there is no possibility of covered interest arbitrage. But it is through covered interest arbitrage in the currency markets, or rather through the threat of it, that equilibrium is ensured in the currency market. If a speculator manages to lock in an arbitrage profit, this would mean that his or hers counterpart looses the equivalent amount on the very same transaction. This is why banks use spreads to reassure themselves against losses. The levels at which these spreads are established is determined by the bank, in conjunction with the exchange, is based on the assessed maximum movement which may be expected in the market on any one day. If not arbitrageurs would be able to borrow in one currency and lend in another, and cover the difference in the foreign exchange market. The mechanism takes advantage of the interest differential that is not fully reflected by, or covered by, a forward premium or discount. This must mean, according to the theory, that if the theoretical forward rate does deviate from the actual forward rate, arbitrage could be pursued.30
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Multinational Finance, p. 96-99, Multinational Business Finance, p. 120-122 Multinational Finance, p. 93-95, Multinational Business Finance, p. 128-130 29 Multinational Finance, p. 95-96, Multinational Business Finance, p. 128-130 30 Multinational Finance, p. 90-91, Multinational Business Finance, p. 123-124, Treasury Management, p. 279, Currency Risk and Business Management, p. 21-22

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

The way a firm deals with currency risk is a key element of financial policy. Failure to set risk management guidelines and then monitor the corporations risk management activities can expose a firm to financial loss or even ruin. Management must decide whether currency risk exposures will be managed, how actively they will be managed, and whether a firm is willing
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Multinational Finance, p. 92-93, Multinational Business Finance, p. 123-124

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

Seminar Paper by Alan V. Deardorff This Seminar paper, written in 1978, examines the relationship between spot and forward exchange rates and domestic and foreign interest rates with transaction costs taken into account. Actually, apart from more conventional analysis, his seminar paper focuses on cost minimization rather than on profit maximization. He states that covered interest arbitrage is all about effectively exchanging, for example, current dollars for current dollars and making a profit in the process. Deardorff stresses that it is well recognized that some departure from exact interest parity is possible in the presence of costs associated with transactions on the securities and exchange markets. He also argues that, with the same conditions regarding transaction costs, conventional covered interest arbitrage will never occur at all. Deardorff concludes that covered interest arbitrage should prevent the percentage deviation of the forward rate from its interest-parity value from ever exceeding the sum of transaction costs involved. Deardorff writes about the phenomenon of one-way arbitrage which is an alternative way to achieve the same result as in a spot market purchase, that is, a replication of a spot exchange, at a potentially lower cost. This can be of interest for a market participant in demand of another currency since everyone is assumed to be rational in their actions and therefore trying to minimize costs in their quest for maximum returns. Deardorff explains that one-way arbitrage, or the market participants knowledge of its possibility, will prevent interest and
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Multinational Finance, p. 304 Multinational Finance, p. 320

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

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

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

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

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

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

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

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

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

Sweden

Norway

Spot rate + pips Investment in Norway

Figure 6 can illustrate the forward deal:


Spot rate

Sweden

Norway

Forward rate

Investment in Norway

These two figures shows how we have been thinking in the experimental calculations. As can be seen, both procedures start with buying NOK on the spot market. Thereafter an investment is made in Norway. The forward rate, in this case, is dependent and calculated on the actual
41 42

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

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

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

44

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

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

4.1

Investment alternatives for CGE&Y

Among the investment alternatives for CGE&Y, both such alternatives that we have found and alternatives perceived by CGE&Y, we have rejected a few. Among others, we found that Posgirot offered similar services to companies that banks do. But, after further investigation we found that their offers where not quite as good as the banks because of lower interest rates on short term investments and the fact that there was no possibility of direct transfers, with immediate value dates, between the companys bank account and the Postal Giro account without losing valuable interest rate days. There are several different instruments the company can invest in. Such as in Treasury bills, Treasury notes, bonds45, corporate- community- and real estate certificates and also in the deposit market. There are different and/or several risks in the stated instruments above, but most of them are in general considered as relatively low-risk investment alternatives. Examples of high-risk investment alternatives are shares, options and different indices that are more speculative instruments, which CGE&Y will not use due to the companys risk policy. When investing the excess cash one must have in mind how liquid an investment should be. This can differ from time to time and very much decides which instrument to use. If there might be a possibility to lock in cash for say three months the company has to look for the highest yield for a three months period. It might however be hard to find an instrument that exactly fits ones investment preferences at all times. So even if the instrument chosen may not run for exactly three months, one can invest the last period of time in the deposit market. There might be many different investment alternatives for the company. CGE&Y themselves perceives four alternatives for their longer investments (one to three months) and we intend to investigate these alternatives. These existing alternatives according to CGE&Y is the following: 1. Invest each country's excess cash in that county and refrain from any transfers at all. 2. Invest all the accumulated excess cash from the Nordic region in Sweden, since Sweden is the largest market in the Nordic for CGE&Y. 3. Invest all the accumulated excess cash from the Nordic region in the country that possesses the highest market interest rate. 4. Transfer the money to currency accounts in the preferred country without ever exchanging the excess cash. Today CGE&Y is using point 1 exclusively and it is considered to work well. No exchange has to be made and hereby CGE&Y isnt exposed to currency risk. Point 2 is could be considered as not reasonable since Sweden presently is a low interest rate country. This alternative might be considered provided that a larger amount of money might give the company a higher interest rate on its investments. Another acceptable reason for this
45

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

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alternative is that the finance center is centralized to Sweden. It could possibly be more easily to run if all the excess cash is transferred to Sweden. Perhaps point 3 is more favorable and can serve as a substitute for point 2 since a higher interest rate should give a higher rate of return. This alternative is also subject for the condition for point 2, that larger amounts could give a higher interest rate of return. Point 4 can after review definitely be taken out of consideration since it would yield the same result as point 1. This is because of the fact that the interest rates on currency accounts are reflected by the general interest rate level in each currencys country46. This leaves us with alternatives 1, 2 and 3. 4.2 Experimental calculations- empirical demonstration of interest rate arbitrage

We shall now make four experimental calculations using both SEBs and SHBs figures respectively and two more with SEBs and SHBs figures in combination to se how these alternatives hold. The last calculation is using the both banks figures and is to represent an investment in Sweden. The calculations are done through our modified calculation model and are executed step by step as we presented earlier, in the theory part. The figures used in the calculations, seen in the tables below, were provided by CGE&Y after having followed the instructions. The spot exchange quotes are to by interpreted from the bank perspective. 113,02 SEK is needed to buy 100 NOK. Of the interest rates only the deposit quote is of interest to these calculations. The forward and swap quotes should be interpreted as the spot price less or plus the forward or swap discount or premium. 4.2.1 Investments for one months time with SHBs figures

Exchange-, Interest-, Forward-, and Swap quotes from SHB as of the 17:th of May 2001, at 09.30
Time 1 month 3 month Time 1 month 3 month S0SEK/NOK Buy 112,80 112,80 Sell 113,02 113,02 Interest rate Sweden % Deposit Lending 4,00 4,10 4,00 4,12 Swap Buy -0,32 -0,96 Sell -0,30 -0,92 Interest rate Norway % Deposit Lending 7,03 7,29 7,23 7,45

FSEK/NOK Buy -0,32 -0,96 Sell -0,30 -0,92

1. Sell 100 million SEK and buy NOK at the spot exchange rate 113,02 SEK/100 NOK 100 million/1,1302 = 88 479 915 NOK 2. Invest for one month in Norway 88 479 915 * ((1+0,0703)/12) = 88 998 260 NOK
46

Interviews with Anneli Petersson, CGE&Y, SHB- and SEB trading center

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3. Sell 88 998 260 NOK and buy SEK on a one month forward contract at the same time to the exchange rate of (112,80-0,32) 88 998 260*1,1248 = 100 105 247 SEK The alternative is to invest the 100 million SEK in Sweden for one month. This would yield; 100 million * ((1+0,04)/12) = 100 333 333 SEK This would result in a lost yield for CGE&Y of 100 333 333 100 105 247= -228 086 SEK due to the spreads built into the transactions. 4.2.2 Investments for three months time with SHBs figures

1. Sell 100 million SEK and buy NOK at the spot exchange rate 113,02 SEK/100 NOK 100 million/1,1302 = 88 479 915 NOK 2. Invest for three months in Norway 88 479 915 * ((1+0,0723)/4) = 90 079 189 NOK 3. Sell 90 079 189 NOK and buy SEK on a three months forward contract at the same time to the exchange rate of (112,80-0,96) 90 079 189*1,1184= 100 744 565 SEK The alternative is to invest the 100 million SEK in Sweden for three months. This would yield; 100 million * ((1+0,04)/4) = 101 000 000 SEK This would result in a lost yield for CGE&Y of 101 000 000 100 744 565 = -255 435 SEK due to the spreads built into the transactions. 4.2.3 Investments for one month time with SEBs figures

Exchange-, Interest-, Forward-, and Swap quotes from SEB as of the 17:th of May 2001, at 09.30
Time 1 month 3 month Time 1 month 3 month S0SEK/NOK Buy 112,25 112,25 Sell 112,85 112,85 Interest rate Sweden % Deposit Lending 4,00 4,10 4,00 4,10 Swap Buy -0,31 -0,95 Sell -0,30 -0,93 Interest rate Norway % Deposit Lending 7,13 7,23 7,25 7,35

FSEK/NOK Buy -0,31 -0,95 Sell -0,30 -0,93

1. Sell 100 million SEK and buy NOK at the spot exchange rate 112,85 SEK/100 NOK 100 million/1,1285 = 88 613 203 NOK 2. Invest for one month in Norway 88 613 203 * ((1+0,0713)/12) = 89 139 713 NOK 3. Sell 89 139 713 NOK and buy SEK on a one month forward contract at the same time to the exchange rate of (112,25-0,31) 89 139 713*1,1194 = 99 782 995 SEK At this stage one can see that CGE&Y would lose money by trying to lock in a profit in a similar way. The company would not even retrieve the principal amount. The alternative is to invest the 100 million SEK in Sweden for one month. This would yield; 32

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100 million * ((1+0,04)/12) = 100 333 333 SEK This would result in a lost yield for CGE&Y of 100 333 333 99 782 995= -550 338 SEK due to the spreads built into the transactions. 4.2.4 Investments for three months time with SEBs figures

1. Sell 100 million SEK and buy NOK at the spot exchange rate 112,85 SEK/100 NOK 100 million/1,1285= 88 613 203 NOK 2. Invest for three months in Norway 88 613 203 * ((1+0,0725)/4) = 90 219 317 NOK 3. Sell 90 219 317 NOK and buy SEK on a three months forward contract at the same time to the exchange rate of (112,25-0,95) 90 219 317*1,1130 = 100 414 100 SEK The alternative is to invest the 100 million SEK in Sweden for three months. This would yield; 100 million * ((1+0,04)/4) = 101 000 000 SEK This would result in a lost yield for CGE&Y of 101 000 000 100 414 100 = -585 900 SEK due to the spreads built into the transactions. 4.2.5 Investment for one month time, using the most favorable figures from both banks

1. Sell 100 million SEK and buy NOK, through SEB at the spot exchange rate 112,85 SEK/100 NOK 100 million/1,1285 = 88 613 203 NOK 2. Invest for one month in Norway, through SEB 88 613 203 * ((1+0,0713)/12) = 89 139 713 NOK 3. Sell 89 139 713 NOK and buy SEK on a one month forward contract, through SHB, at the same time to the exchange rate of (112,80-0,32) 89 139 713*1,1248 = 100 264 350 SEK The alternative is to invest the 100 million SEK in Sweden for one month. It doesnt matter which bank the company use, since it is the same deposit rate offered in both cases. This would yield; 100 million * ((1+0,04)/12) = 100 333 333 SEK This would result in a lost yield for CGE&Y of 100 333 333 100 264 350 = -68 983 SEK due to the spreads built into the transactions. One can see that the company would not loose as much money by utilizing both banks. Either - 228 086 SEK in SHBs case or -550 338 SEK in SEBs case. 4.2.6 Investment for three months time, using the most favorable figures from both banks

1. Sell 100 million SEK and buy NOK, through SEB at the spot exchange rate 112,85 SEK/100 NOK 100 million/1,1285 = 88 613 203 NOK 2. Invest for three months in Norway, through SEB 88 613 203 * ((1+0,0725)/4) = 90 219 317 NOK 3. Sell 90 219 317 NOK and buy SEK on a three month forward contract, through SHB, at the same time to the exchange rate of (112,80-0,96) 90 219 317*1,184 = 100 901 284 SEK

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The alternative is to invest the 100 million SEK in Sweden for three months. It doesnt matter which bank the company use, since it is the same deposit rate offered in both cases. This would yield; 100 million * ((1+0,04)/4) = 101 000 000 SEK This would result in a lost yield for CGE&Y of 101 000 000 100 901 284 = -98 716 SEK due to the spreads built into the transactions. One can see that the company would not loose as much money by utilizing both banks. Either 255 435 SEK in SHBs case or 585 900 SEK in SEBs case. We also want to investigate if the parities hold the other way around, that is, transfer capital from NOK to SEK, invest in Sweden and at the same time buy NOK for SEK on a forward contract. This calculations are done below: 4.2.7 Investment for one months time in Sweden, using the most favorable figures from both banks

1. Sell 100 million NOK and buy SEK, through SHB at the spot exchange rate 112,80 SEK/100 NOK 100 million NOK*1,1280 = 112 800 000 SEK 2. Invest for one month in Sweden, through SEB or SHB (it gives the same yield) 112 800 000 * ((1+0,04)/12) = 113 176 000 SEK 3. Sell 113 176 000 SEK and buy NOK on a one month forward contract, through SEB, at the same time to the exchange rate of (112,85-0,30) 113 176 000/1,1255 = 100 556 197 NOK The alternative is to invest the 100 million NOK in Norway for one month. This would yield; 100 million * ((1+0,0713)/12) = 100 594 167 NOK This would result in a lost yield for CGE&Y of 100 556 197 100 594 167 = -37 970 NOK due to the spreads built into the transactions. 4.3 Correlation between the Nordic currencies

We decided to investigate the correlation between the Nordic currencies in purpose of reasoning about the need for hedging when exchanging these currencies. We were told by Oxenstierna47 that the Nordic currencies have not been especially correlated in the past, especially not the Norwegian and Swedish currencies. However this statement is probably quite subjective, but is confirmed by chart 1. Through this statement we got interested of investigating how the DKK, FIM and SEK were correlated to each other. We believed that this could be of interest for CGE&Y in hedging decisions, that is, whether it is relevant and necessary to hedge when exchanging currencies between the Nordic branches. As can be seen in chart 1, this is not the case. However, the DKK, FIM and NOK have a high correlation, whereas SEK obviously deviates from all of them. This could help display between which branches the hedging need is apparent and between which it is not.

47

Ph. D. of Economics at Sdertrns hgskola, CeFin

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NOK=, Close(Bid) [Line] SEK= DKK= FIM= Daily 09Jun00 - 07Jun01 Pr / USD 10 9.5 9 8.5 DKK= , Close(Bid), Line 31May 01 8.7800 FIM= , Close(Bid), Line 31May 01 7.0032 NOK= , Close(Bid), Line 31May 01 9.3426 SEK= , Close(Bid), Line 31May 01 10.7560 Pr / USD 9.2 9 8.8 8.6 Pr / USD 8.6 8.4 8.2 8 7.8 Jul Aug Sep Oct Nov Dec Jan01 Feb Mar Apr May Jun

Pr / USD

6.8 6.6 6.4 6.2 Jun00

Chart 1; Correlation of the Nordic currencies

The diagram is supplied by SHBs trading center and shows one year of daily close bids on the spot currency exchange market. 4.4 4.4.1 The over-night investment situation for CGE&Y Investigation of the 11 oclock rule

We will here conduct the experiment regarding the 11 oclock rule. Invest 100 million SEK every day, over-night, in one year. Alternative 1 The annual over-night interest rate CGE&Y receives is at current 3,95 %. This results in ((0,0395/360)+1)360 4,0288 % compounded interest rate per year. That is 4 028 800 SEK per year. This is an interest rate that is not dependent on how small or big the investment is. That is, CGE&Y get this interest rate on all its over-night investments at present. And it has not fluctuated at all the past six months.

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Alternative 2 If CGE&Y was to receive 4,05 % annual over-night interest rate, the compounded interest rate per year would be ((0,0405/360)+1)360 4,1329 %. That is 4 132 900 SEK per year in returns on a 100 million SEK daily investment. Alternative 3 If CGE&Y were to invest 70% at 4,05 % annual over-night interest rate and 30 % at 3,95 % annual over-night interest rate it would give the following annual compounded interest rate. 0,7*((0,0405/360)+1)360 + 0,3*((0,0395/360)+1)360 4,1017 %. That is 4 101 700 SEK per year in returns on a 100 million SEK daily investment. The difference between alternative 1 and 2 would hereby be: 4,1329-4,0288 = 0,1041 % compounded interest rate per year. That is 104 100 SEK. And the difference between alternative 1 and 3 would be: 4,1017-4,0288 = 0,0729 % compounded interest rate per year. That is 72 900 SEK. Invest 100 million SEK, over-night, for one day. Alternative 1 If one calculates the amount CGE&Y get at current for a one-day over-night investment on 100 million SEK, it looks like this. 100*((0,0395/360)+1) = 100 010 972 SEK As can be seen, CGE&Y would earn 10 972 SEK for this day. Alternative 2 If CGE&Y were to invest to 4,05 % annual over-night interest rate it would look like this. 100*((0,0405/360)+1) = 100 011 250 SEK As can be seen, CGE&Y would earn 11 250 SEK for this day. Alternative 3 If CGE&Y were to invest 70 million SEK for one day before 11.00 oclock at 4,05 % annual over-night interest rate, and to invest the remaining 30 million SEK for one day after 14.30 oclock at 3,95 % annual over-night interest rate it would yield the following amount. (70*((0,0405/360)+1)) + (30*((0,0395/360)+1)) = 100 011 167 SEK. This means that CGE&Y would earn 7 875 + 3 292 = 11 167 SEK for this day. The difference between the alternatives 1 and 2 would give CGE&Y a profit of 100 011 250 - 100 010 972 = 278 SEK for that day. The difference between the alternatives 1 and 3 would give CGE&Y a profit of (70 007 875 + 30 003 292) - 100 010 972 = 195 SEK for that day. Observe that the first three calculations are made with an compounded interest rate whereas the three last calculations are made with a face interest rate. As can be seen in the calcultions, it would be favorable for CGE&Y to invest its access cash before 11 oclock due to the potentially higher interest rate.

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4.4.2

SASs interest rate netting through SEB and results from the interview

By interviewing SAS we got to know that the company applies interest rate netting between the Nordic countries. This is something that CGE&Y are not able to do caused by its main bank SHB. The situation is best explained by an example: SAS Denmark has around 8 million DKK on its account in Denmark, which is equivalent to about 10 million SEK and SAS Norway has around 9 million NOK in excess cash on its account in Norway, which is equivalent to about 10 million SEK and SAS Sweden has 10 million SEK in excess cash. The total amounts of excess cash for the three countries are 30 million SEK. Now, these counter-values can be viewed and are controlled by SAS Treasury Department. Suppose the interest rates are: in Denmark 5%, in Norway 7% and in Sweden 4%. What SAS does is to virtually transfer these counter values from Denmark and Norway to the Swedish account. This provides the Treasury Department in Sweden with a larger amount to invest in the market. By doing this the company will get a higher yield than a lower amount, say 10 million SEK, would yield. Even though the interest rates are higher in both Denmark (1% higher) and Norway (3%higher) than in Sweden, it will not make any difference, because SAS will get these percentage differences due to the exchange rates built into the virtual transactions. The figure shows the example: 7%
SASs account in Norway

4%
SASs account in Sweden

5%
SASs account in Denmark

3%

1%

+10 MSEK

+10 MSEK

+10 MSEK

Figure 7; SAS interest rate netting example

One can hereby say that SAS get 5% interest rate on the Danish money, 7% on the Norwegian money and 4% on the Swedish money. By investing 30 million SEK in the market the company will get some extra interest due to the larger amount to investment, but how big that difference is may differ from time to time. The interest rate netting system is very timesaving and rational according to SAS. There is also an administrative process involved for every transaction and contract that a company signs and this work is also minimized through the netting system. Internal netting between company branches is performed automatically. If one of the company branches is in a shortfall of liquidity, any positive balance in any of the other branches automatically offsets this negative balance. The most valuable information we got through the interview was the 11.00 oclock rule, presented earlier, which implies that a company shall get in contact with banks before 11 oclock so that it has a greater possibility to bargain. Other valuable information we got was about the interest rate netting between countries and interest rate swaps and the fact that banks call SAS for different investments and offer them better interest rates than their main bank, due to the fact that SAS Treasury Department is known in the market.

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4.4.3 Results from the interview at Ericsson Treasury Services When we were at Ericsson we learned that the company swap all its different currency accounts money to USD. The reason for that procedure is that the company can net out all its accounts to the joint bank account and get only one amount to invest or borrow. The advantage of swaps is that it eliminates the currency risk. One reason for investing or borrowing in USD is that USD is the most efficient currency to trade, that is, lowest spreads and the most liquid currency. In the interview we learned that the companys dealers are to decide, within the frames of the companys risk policy, where and when to invest or borrow, and in which instrument to invest or borrow. The risk policy has to be followed strictly and are updated all the time by the Risk Management Department.48 4.4.4 SEB as a bank alternative

SEB offer a similar product as SHBs NordicLink with cash-pool-overview and possibilities to transfer money between the companys accounts. It is called SEB-Screen and a feature that it provides is that the connected company can view even non-SEB accounts through SWIFT MT940 messages. SEB provides different features for cash pooling and netting systems. These features include cash pooling of domestic accounts and foreign currencies. SHB offer that as well, but the interesting features that SEB offer is pooling of domestic currency to EUR, from here on referred to as DCTE and interest compensation pooling, from here on referred to as ICP. The DCTE enables the company to convert all its different accounts balances into a EUR joint bank account. All overbalanced and underbalanced accounts will automatically and instantly be converted and transferred to the EUR joint bank account. This means that the different accounts except the EUR joint bank account that the company holds will continuously show a balance of zero. ICP is useful for companies that wish to add an additional level of pooling to their existing cash pools in different currencies. Another reason for an implementation of the system is if the company is not allowed to set up cash pools, due to legal restrictions and internal policy rules. ICP makes it possible for a company to net out overbalanced and underbalanced accounts for interest rate calculation purposes. There are no physical transfers involved. All accounts may be included in this function and it can be performed in all currencies. This is a system that SAS work with.49 According to Kihlman50, SEB doesnt sell the product ICP to often. What type of product SEB implement with a company is dependent on the companys specific needs, the relation to the company and the flows that the company have. Deals are negotiated from customer to customer to make sure that the customer gets what is needed in its specific case.

48 49

Interview with Haller at Ericsson SEBs website 50 Telephone interview with Kihlman at SEB

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4.4.5

On-line dealing

To investigate this matter we have been in contact with Freningssparbankens-, Nordeas-, SEBs- and SHBs trading centers. Freningssparbanken and Nordea did not have the on-line dealing product. SHB will in the end of 2001 present a similar product. This leaves us with SEB that according to themselves is the only bank or financial institution that can offer this product. The SEB on-line dealing system is called Trading Station and is free of charge. It is specially designed for companies that are looking for a fast and easy way to manage their own financial matters, without the help of a broker. With Trading Station a company can carry out currency, fixed income and futures trading, via the Internet. It also gives real-time access to foreign exchange rates, interest rates, equity indices, commodity prices, market information and other news. By making a few clicks on the computer a company can buy and/or sell all major currencies directly via the Internet. The moment a rate change occurs on one of the exchanges, Trading Station updates that price instantly. A company can easily create its own customized information pages in order to monitor the markets that are of particular interest to the company. A company can trade currencies and receive foreign exchange spot and forward information in the form of real-time rates from the global interbank market. Trading Station also shows the highest and lowest buying rates for the day.51

51

SEBs website

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5 Analysis and conclusions

5.1 5.1.1

General analysis and conclusions Capital market equilibrium

In the interview with SAS we were told that you cant beat the market, meaning that the parity theories hold in practice. This was sort of a turnaround for our thesis. From previous courses we have taken we had understood that arbitrage business probably would be very difficult but still, perhaps possible. We have been taught that the capital markets around the world are probably the most efficient markets there are to be found and that the parities hold in a perfect market. But the expression perfect market made us react a little. What is really meant by perfect in this sense? Different authors have pointed out the criteria that are to be fulfilled in the perfect market. But are they really fulfilled? And if they are not, do the spreads really cover the discrepancies at all times? The expression perfect market sounds way to theoretical for us just to take for granted. In our second interview Ericsson confirmed SASs statement but at the same time we learned that Ericsson Treasury Department actually sometimes do, although very seldom, find arbitrage opportunities. However, when they do, the percentage profit margins tend to be extremely small which makes these opportunities more or less negligible. Even though there might be errors in the market that enables arbitrage opportunities, the market itself ensure that this should not be possible because of the high market effectiveness. What we mean is, if arbitrage opportunities would prevail, every active market participant would try to take advantage of the errors, which in turn would strive the market back to equilibrium again. This thought is contingent with all the literature we have read and was also confirmed both by SEBs- and SHBs trading centers as well. Hereby we conclude that it is no idea for CGE&Y to try to make arbitrage business. Whether or not the market is perfect is irrelevant due to the presence of transaction costs. In order to provide empirical evidence for this hypothesis we implemented the theory into practice and conducted the experimental calculations. It would not be good enough just to interview a number of persons in different positions who can be assumed to, but probably do, possess knowledge about our subject. It would be far too subjective. However, we believe they do provide additional support for our results. We also find strong theoretical support from, among others, Butler52 and Eiteman, Stonehill and Moffett53 and Kenyon54. The results made clear that the market actually is so effective that CGE&Y would not even be able to obtain an equivalent yield, but would actually lose on making investments in another country by exchanging currencies. In one of the experimental calculations even the principal amount was deteriorated. The banks spreads are so large that there is no value added from this procedure. One can here again state what we have learned from our investigations; if this procedure would add value, everybody would pursue it. Hedvalls55 working paper also provides support indicating that even professional finance traders attitudes are that arbitrage does not prevail. His results point out that the market is so
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Author of Multinational Finance Authors of Multinational Business Finance 54 Author of Currency Risk and Business Management 55 Author of Arbitrage in an experimental securities market

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effective, or is assumed to be, that market participants dont bother scanning for arbitrage opportunities in the market. Perhaps this has become the case since the opportunities are so rare and the potential margin so low. This is also contingent with Hallers56 statement. In line with Deardorffs57 conclusions, any theoretical profit due to temporal disequilibria is eliminated by transaction costs. That is, banks will always try to make sure that transaction costs, the spreads, have larger percentage deviations from the theoretical equilibrium value than any actual deviation. It is pretty logical though, knowing that ones counterparts, the bank, would lose on every deal made if this would not be the case. Since we have concluded that the theory of interest rate parity holds within the bounds of transaction costs in practice according to the results, one can say that it doesnt matter in which country CGE&Y invests in. This is furthermore evidenced by the fact that we also proved that it doesnt matter which way one goes, that is, the calculation in point 4.2.7. The interest yield loss was slightly lower if one went the other way around, due to SEBs higher deposit rate in Norway, but still, the parities hold with margins. We believe it will give the same net effect wherever the company invests as long as one is considering the same instruments and stays within the frames of the companys risk policy. However, we would like to point out that the company should try to invest only one amount though. This might sound as if we are contradicting ourselves but we are not and this will be discussed further more below. 5.1.2 The risk policy

As it is stated in CGE&Ys risk policy, the company is not willing to take any risks at all. This is a fairly common definition by companies according to Ericsson and SAS. We believe the company has a fair view in its risk policy. CGE&Y is at current developing a new risk policy document, which we havent been able to read. When developing a risk policy as we described in the theory part, it is important to company management to decide how different risk exposures are to be managed, how actively they will be managed, evaluate the cost/benefit from each alternative and estimate how sensitive the company is to the risks. We believe that it is important to revisit the stated risk policy to be able to adapt to different situations/conditions that the company is exposed to. Alfonsi58 says that risk concerns in international treasury are well managed by best-in-class companies, but on the other hand not over-managed. According to the company itself it is only to operate in the consulting business and shall not speculate with its capital. We are unanimous with this point but want to point out that the definition take any risk at all doesnt hold. This hypothesis is strengthened by Rich Joness quote in Blooms59 article: no matter were a treasurer puts the companys cash, it is exposed to risk. By investing at all and using the financial market, there are always different risks involved. These risks are referred to as currency-, interest-, credit-, inflation-, and liquidity risks60. One can never neglect these factors. Further more Bloom stresses that the treasurers primary aim is to invest cash responsibly. Of course different instruments and actions differ in risk, but even the slightest risk has to be taken into account. Both in the Ericsson and SAS interviews we got this hypothesis confirmed. In every investment decision future expectations have to be considered. Not only for how long an investment shall be, but other factors surrounding the investment decision. These are
56 57

Inaterview with Haller at Ericsson Author of One-way arbitrage and its implications for the foreign exchange markets 58 Author of Best practices in international treasury management 59 Author of More reward with less risk: Investment options for corporate treasury 60 See definition in glossary, Appendix A p. 53-57

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mostly macro factors like: interest- and inflations rates and government finances such as expectations on future economic politics, the GNP growth, the budget deficit and the national debt. Companies can take use of the banks, which provides prognosis and analyzes on how they expect the markets to move depending on these different macro economic indicators. These prognoses can often be valuable for a company, especially for one that doesnt have a large Treasury Department in order to get help in predicting the tendencies of the market, or perhaps find support for ones own expectations. By predicting market movements and tendencies, one can invest in countries that will give a higher rate of return due to the difference in actual inflation and interest rates. For example, if the banks predict the DKK to appreciate towards the SEK, a company could exchange SEK for DKK on the spot market and invest in Denmark. If, say after three months, the DKK is stronger than the SEK as the banks predicted and the company exchanges DKK for SEK on the spot market it will give a higher net yield in SEK. A problem might be that when these prognosis and analyzes reaches the market it has already started to move. As can be seen in chart 1, the correlation of the Nordic currencies DKK, FIM and NOK are highly correlated, but not the SEK. One could think that CGE&Y could take a tiny risk by not hedging DKK, FIM and NOK towards one another in purpose of gaining a higher rate of return made possible by lower transaction costs. When investing without hedging, it should be done with a strict analytic underlying investigation. According to Alfonsis article, when describing treasury function development, reasonable risk factors should be identified and thereafter mitigated. When making such a decision, wheatear to hedge or not to hedge, the banks prognosis can be taken into account. As Dhanani61 states, in an effective market, as one can consider the market for DKK, FIM and NOK to be, avoiding hedging could be more profitable due to the higher bid and ask forward spreads compared to spot exchange transactions. Dhanani concludes with stating that this procedure will be surrounded by an active risk, known as currency risk. It is here, at this point, that the companys risk policy has to be taken into account. For example: will and can the company trust the banks prognosis and hereby take active risks? As most often, the company has to investigate if it is worth taking the risk, comparing the possible profit against the possible loss. 5.1.3 The Finance Center

To start with, we are concerned with the decision of letting one person handle the treasury functions in only one to two hours a day. Through the interviews we have done, we think that this could be to little time to set off for this work. Further on we find it puzzling that the company decides the time consumption even before the new system is developed, implemented and tested. Alfonsi does stress the importance of keeping cost base low, but he also stresses that resources in the form of time and money should be spent on information gathering and management. For best-in-class performers quality information is very important. Is one person really capable of both consuming quality information and at the same time perform the necessary tasks for each day? We believe this to be a bit ignorant and react to their approach to the financial market. The market exists to help companies get a better and more effective handling of investments, receivables in different currencies and so on. This means that, rather than to neglect its functions, CGE&Y should take time to investigate and try to analyze what the market place can improve in their specific case and take advantage of its functions. Of course the company should have a specified time-consumption goal, this is not what we disagree to. It is a good thought to reduce costs. But the company is dealing with fairly large amounts of capital and we would think that the management has to review the pre-

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Author of To hedge or not to hedge

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decided time-consumption limit, set to run an effective Finance Center. It might be less costly to be an active market participant compared to not be a part of the market! 5.1.4 Investment alternatives

After investigating the four investment alternatives for CGE&Y stated by the company itself we can make some conclusions that are supported by the theories we have found: The first alternative, to invest in each country, is what the company does today. This alternative is just about the same as number four, which proposes that the company should invest its excess cash in currency accounts. This is actually what alternative four tells us, since one cannot for example invest SEK in Norway or DKK in Sweden. By using alternative one or four the company will get the same interest rate due to that the interest rates on currency accounts are reflected by each currencies domestic interest rate. We think that these two investment alternatives should be taken out of consideration. The company has to do four different investments, one each in EUR, DKK, NOK and SEK and implies unnecessary administration time and costs. It will be four small investments that consequently give a lower return than what would be the case if the company had only one larger amount to invest in one currency. We believe CGE&Y must find a way to make this possible. Alternative two, to invest all the excess cash from the Nordic region in Sweden is the most favorable according to us. This alternative is favorable because the companys main operations in the Nordic are in Sweden and the fact that the Finance Center shall be situated there as well. As Alfonsi says it is important with good personal relations and these are easier to achieve if one is perceived as a key customer. Since netting is not allowed, the company could possibly swap (or spot/forward) its excess cash from the rest of the Nordic to either EUR or SEK to make only one investment in one of these currencies. This procedure is pursued only to be able to invest a larger amount that might give a higher rate of return compared to investing several smaller amounts. Observe that in this procedure there will only be one transaction when making the actual investment, but several ones when exchanging and hedging the different currencies. This specific procedure will be further explained under 5.3.2. This is subject to the matter of investigating the netting possibilities for the company so the company doesnt have to administer all the exchange and hedging transactions. Alternative three to invest all the Nordics excess cash in the country that possesses the highest market interest rate is through the results from the empirical calculations and interviews out of question. We cant see any reason for investing in say Norway, even though Norway for the moment has the highest interest rate level. Furthermore, it would probably only be difficult to operate on the Norwegian financial market when the finance center will be situated in Sweden. It is of more value with good bank connections on the Finance Centers home market. 5.2 5.2.1 Analysis and conclusions on the long-term, one to three months The experimental calculations

When looking at the problem for the first time, one can think that it would be clear that CGE&Y should invest its money in Norway. Simply because Norway at present do have the highest interest rate level in the Nordic region. This is the main problem that CGE&Y wanted help to investigate. CGE&Y should not invest its excess cash in Norway. At least not with the 43

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intention to earn a profit in the procedure. The interest rate differences are erased partially by inflation and partially by the forward exchange rate, and the spreads in the transactions are also erasing parts of the amount invested. We have hereby concluded that this procedure only would imply a cost for the company. As we stated in the calculation model: only the deposit market is considered. The figures received from the two banks are taken as examples. If CGE&Y was to do the same procedure and instead invest in a Norwegian corporate certificate that give a higher yield compared with the deposit market, another yield would apply and the outcome would be different. But on the other hand, a similar comparison of a corporate certificate bought in Sweden would probably prove to present the same results as the Norwegian certificate would give. However, how the outcome differs depending on what instruments one is using was never something we intended to examine. We are though fairly certain that the result would be the same if performed with corporate certificates as well. What we mean is that the theories of interest rate parities hold in general if one make comparisons under the same circumstances. 5.3 5.3.1 Short-Term, the over-night investment situation The 11 oclock rule

We have concluded that large companies through agreements with their banks are in general allowed to make money transfers larger than 10 million SEK between different banks before 14:30 in the afternoon without losing any interest yield for that day. As stated in transfer deadlines, point 1.2.2.1, amounts less than 10 million SEK has to be transferred before 11 oclock to get the same value date. This 11 oclock deadline is of interest when making investments. If a company is looking for an investment that will yield a higher rate of return than its main bank can give, the company should invest before 11 oclock. This is because the company can transfer capital between banks, which mean that, the company still has a bargain position towards the banks. Consequently, the banks are willing to pay a higher yield, since they know that companies can use different banks when making the investment before 11 oclock. We also guess that the banks in general are more eager in the mornings to obtain capital to cover its lending demands during the day. CGE&Y doesnt use the 11 oclock rule at current. By not using this rule and utilize a stronger bargain position the company lose the possibility to gain a higher yield on its over-night investments. We concluded this in the calculations made in the investigation of the 11 oclock rule. In fact, CGE&Y voluntarily gives its bank, SHB, a monopoly on its over-night capital by making their investments in the late afternoon. The results that we found through the calculations showed that the effect is fairly large and we believe that CGE&Y should adapt to this rule. We support this statement with the fact that CGE&Y often has more than 100 million SEK to invest over-night, which enables the effect to become even larger than in our experiments. In the interviews with both SAS and Ericsson we learned that they have the ambition to be done with the deposit investments by 11 oclock. Furthermore Ross62 stresses that a company should contact at least two banks before deciding where to invest and that there might be different quotes given from bank to bank. We believe that CGE&Y should try to improve the possibility to invest its excess cash before 11 oclock. The most profitable procedure for CGE&Y would of course be to invest 100 % of its excess cash before 11 oclock as the results show in the calculations. But, we believe that it would be sound for the company to start off by for example investing up to 70 % of its
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Author of International Treasury Management

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assessed excess cash before 11 oclock and at the same time maintain 30 % for eventual emergency payments. We believe this to be a good idea before the company has achieved good routines to handle this problem. By investing by the 70-30 % procedure the company still earn money compared to how the investments are done at current. Another feature of remaining 30 % is that the company still can retain the advantage of being able to wait until late afternoon to make the investments without risking current company liquidity. Making the business fields prognosticate their daily excess cash more effectively could solve the problem. This would enable the finance center to invest as much of the companys total accumulated excess cash as possible before 11 oclock. 5.3.2 Make the investing process more effective

If CGE&Y will not be able to pursue interest rate netting, we believe that CGE&Y should investigate the possibility to convert (swap or spot /forward) all currencies to one currency to be able to invest only one larger amount in the market. Ericsson employs this procedure and they consider the system to be very functional. But, on the other hand, Ericsson often has very large amounts to invest in the market and can therefore get good deals from the banks and herby can Ericsson Treasury Services act as an internal bank for the whole Ericsson group. For example: suppose that the interest rate in Sweden is 4 %, which the pips and forward contract is calculated from, but when investing a larger amount CGE&Y could potentially get 4,10 % interest rate. According to the parity theories, CGE&Y would profit from this procedure, that is, the interest rate difference, which is 0,10 %. The excess interest rate income must however exceed the transaction costs from these transactions and hedges. Unless this is not the case, the company will only incur a yield loss. Note that this procedure differs from the conditions in the empirical demonstration of interest rate arbitrage, point 4.2, in the usage of different interest rates. In these experimental calculations we did not consider the possibility of attaining a higher rate of return from a larger amount. This just might not be possible anyway but it sure would be interesting to try! The disadvantage of converting all currencies is that there will be higher administrative cost for the company. These costs should be considered when analyzing the total cost/benefit picture. We believe that the most profitable currency to swap to is the EUR. The reason is because CGE&Y in the Nordic has EUR joint bank accounts already that would make it easier to transfer money and not as many hedges has to be bought. By reviewing figure 3, one can se that if netting against the EUR there will only be three swap deals needed. The second best solution is to swap it to SEK, since this is the currency mainly used in the region. Even though this would mean that CGE&Y would have to make six swap deals, due to the fact that its EUR accounts can not be netted without charges between the countries. As stated in the SAS interview, banks call SAS in the purpose of offering different investment alternatives. We believe that CGE&Y should market itself in the market to be able to get similar contacts with several banks in the Nordic region. We think that the company ought to have the ability to strengthen its relations due to the companys size. We believe that banks are interested in companies that often have large amounts of excess cash. Even though the 650 million SEK as in CGE&Ys case might not be that much. Whenever a company is about to buy, sell or hedge currencies, and invest or borrow money, it has to make sure that it doesnt reveal which position it is intended to take. This is why a company shall get quotes for the two positions, both buy and sell, that may be taken before a monetary transaction is done. The reason for this is that the bank will otherwise know which position a company is about to take and can therefore quote the rate in favor to itself. 45

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We learned in the interview with SAS that some banks have an on-line dealing product. We investigated this and found out that it was at current only SEB that can provide this service and that SHB are about to implement it. We believe that on-line dealing could function as a compliment to telephone contact with banks for CGE&Y in the future. The SEB on-line dealing system is free of charge and should definitively be investigated by CGE&Y. The system has a drawback that one has to consider though. When a company is bidding on a currency, it is revealing which position it is about to take, that is, buy or sell. We bet the banks find this very convenient. 5.3.3 Drawbacks with the SHB agreement and comparison to the SEB alternative

We think that the NordicLink system and the negotiated agreement between CGE&Y and SHB have some drawbacks. One is that the company will not be able to perform netting between the different joint bank accounts in the Nordic. Another is that CGE&Y will have to pay (even though it might be low fees) for transferring EUR between the different Nordic EUR joint bank accounts. These agreements are most certainly lucrative out of SHBs perspective. One could think that it would be free of charge to transfer EUR between the different countries since it is the very same currency. One of the explicit benefits used by SHB to sell the NordicLink system is, after all, the ability to make quick and free of charge transactions, except when exchanging currencies. This particular benefit is now threatened if CGE&Y doesnt disagree and protest. The reason that CGE&Y choose SHB in favor of SEB or any other bank was according to Petersson that CGE&Y considered SEB to be more costly in annual and transfer charges. The question remains; if CGE&Y would have chosen SEB, wouldnt these charges have been small in comparison to the possibility through SEB pursue netting between the countries? In this question we can only speculate because the banks differ in charges from company to company. This however is nothing that we had intention to investigate in this thesis, but it ought to act as a teaser for CGE&Y! Products as SEBs DCTE and ICP that are presented in the investigations could be of value for CGE&Y. We are certain that CGE&Y could, by putting a little pressure on SHB, get similar sorts of systems provided through them as well. Actually we have been in contact with SHBs Cash Management Department for companies. They told us that a company that has around 100 million SEK to invest over-night every day should without any doubts be offered the ability to perform interest rate netting between the Nordic countries. We believe that by using a system like DCTE the problem of not being able to pursue netting between the countries and to avoid the fee on transfers of EUR between the countries would be solved. How costly such a system would be compared with the loss of not being able to pursue the functions stated above is, as well, dependent on the companys relation to the bank. We have after our interviews been convinced that CGE&Y can demand more from its bank. According to SAS the interest rate on the over-night investments that CGE&Y receives is far to low and should be a couple of points higher. The bank relation is important, this is something that Ericsson, SAS and Ross stresses. 5.3.4 Advantages/disadvantages with interest rate netting

By performing interest rate netting a company can advantageously accumulate all its excess cash in one currency without any costs involved and invest only one larger amount in the market, as the SAS example in our investigation. We believe that another advantage could be if a company branch is fairly good at planning its liquidity, it could very well minimize the usage of the expensive bank credit or even short-term loans. 46

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However, we think there might be a disadvantage in a solution of this kind. Even though there is no physical transaction, we believe that there is a spread built into the exchange rates that the counter-values are calculated through. What we mean is that this counter-value is lower than the actual balance on each account in the different countries connected to the interest rate netting system. However, we chose not to speculate if there might be any gains for the bank. And even if there would be, the benefits for the company would probably outweigh the possible drawback. 5.4 Recommendations for CGE&Y

-CGE&Y should not transfer and exchange excess cash between the Nordic countries in investment purposes unless the excess interest income exceeds the costs for the exchanges and hedges needed. -All balancing on each business fields account has to be supplied to the Financial Center so that investments can be made before 11.00 oclock. If a business field cant manage this before 11.00 oclock it will get a lower rate of return on its excess cash. After a business field has supplied the Finance Center with its assessed excess cash it cannot retrieve any amount without being charged with an internal credit interest rate. This is to speed up the efficiency of the flows within the company by putting a little pressure on the different business fields administrations. -Investigate the on-line dealing through SEB, which is available today, to be able to fast and easily get an overview on what the bank offers. Several banks are currently developing similar services. The benefit is that CGE&Y can get different rates and quotes more time-efficient. -The EUR accounts in the Nordic should be netted in order to get a larger amount to invest in the market. A potential benefit is that the Nordic region will probably be more dependent on the EUR in the future. Another acceptable reason for the proposed procedure is that CGE&Y Finland uses EUR as its main currency due to the EMU membership and that CGE&Y in Denmark, Norway and Sweden has EUR joint bank accounts. -If interest rate netting is still not allowed, the company could swap the currencies in question. That is, DKK to EUR, NOK to EUR and SEK to EUR. Instead of investing four different amounts and get a normal rate of return, this procedure might be advantageous due to the larger amount that the company hereby can invest in the market and attain a higher rate of return. -Continual pressure on SHB to be able to pursue interest rate netting between the countries. Dont put to much confidence into SHB, be critical and compare the bank with its competitors. What do they have to offer? Which factors weight the most for CGE&Y? If CGE&Ys prompting is rejected by SHB, we believe they should look for better alternatives, maybe even switch banks. -CGE&Y has to understand/realize that they can negotiate and bargain to get better rates of return. This is evident especially for the deposit market. All it takes is fundamental understanding of how to act in order to strengthen the companys own bargaining position.

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-When shopping around, one should never reveal what position one intends to take. Make sure to get both bid and offer rates. This should be done so the bank doesnt set the rates to be more favorable for itself. -The treasury dealer should obtain quotes from several banks, or at least two, before choosing one to transact the deal. A bank with a large book in the cross-currency will generally be able to quote attractive rates and these are often banks that originate from the country where one currency is its domestic currency. Other banks to approach are those that have strong links with the country from which the currency originates. Sometimes banks have surpluses, long positions, of its domestic currency and a company wishing to sell that currency may therefore receive a poor quote63. -CGE&Y should market themselves on the financial market. Good relationships and a good name are advantageous. Let most banks on the Nordic market know that CGE&Y is a company that quite often has more than half a billion SEK to invest. -We believe that the management should consider reviewing the pre-decided timeconsumption limit, set to run the Finance Center. The company is dealing with fairly large amounts of capital and CGE&Y should take time to investigate and try to analyze what the market place can improve in their specific case. 5.5 Critical review

We think it might be a weakness that we only made the Sweden Norway calculations at one single point in time. We could have gotten more figures from different dates, that is, conducted the procedure several times. The reason for not doing this was lack of time. But we believe that we would have gotten about the same results, according to the theories it would be quite unnecessary for us. After all, we have confirmed an already acknowledged hypothesis. To give a more company-related comparison we could have interviewed companies of more similar size and operations. We simply got in contact with the selected larger companies because we assumed that they had well functioning and experienced Treasury Departments. Benchmarking does after all mean: to compare with the best. In our thesis we have not taken real interest rates into consideration. We chose only to investigate nominal interest rates. A reason for this is that we find ourselves to unfamiliar with the concept of real interest rates and its implications. During our work we have managed to grasp some of the relationships implied be real interest rates. Furthermore, we have not investigated what real financial instruments there are and which perhaps could be of interest to CGE&Y. Consequently, we have not taken inflation risk into consideration either. Also we never investigated what gains there are with tom-next investments, tomorrow next, investments in the deposit market. It just might be so that this alternative, which ties up the money for two days, gives a higher yield. This aspect slipped our minds totally.

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We have only considered investment alternatives that are consistent with CGE&Ys risk policy. Perhaps this might have limited us in our investigation. Perhaps we would have been more open minded and looked for other alternatives. The literature we have used is very theoretical in general. There have been little practical connections to reality as we have found it. Not that the theories in the literature did not hold, as we have proven, they do. But, we havent found any literature that explains how a company in specific, like CGE&Y, work with treasury matters. Our investigations could have been more thorough if we would have had more time. An example is that we never interviewed an insurance companys capital administration department that we actually were planning to do. Another criticism of ourselves is that we couldnt make up our minds in deciding in what we in specific were going to investigate. We realized rather late that our ambitions from our first stated purpose had been too wide. This made us rather late starters, which perhaps can have had implications for the thesis. We think we should have investigated the correlation of the Nordic currencies towards the EUR since: 1, CGE&Y Finland already uses EUR as its domestic currency, 2, we have predicted the EUR to rise in significance to CGE&Ys Nordic region as a whole, 3, CGE&Y accounts its results in EUR to the parent company. 5.6 Suggestions for further research

We would like to suggest further investigation on how real interest rates can be attained and the different real financial instruments available to CGE&Y. Perhaps the same relationships apply here as with nominal interest rates. We would also like to recommend an investigation for different investments alternatives that CGE&Y in general could use in search for a higher rate of return. For example if there might be instruments in the Nordic that we dont know of, or if for example corporate certificates in Finland gives a higher rate of return due to a rougher company climate. Investigate the matter from a more risk willing perspective. What would happen if the company would chose not to hedge the transaction exposure through a forward contract? What would the excess cash returns and perhaps losses be? How large risk premium would the company demand in reward for such a risk? Another suggestion is to look into the whole bank situation in CGE&Y. Are there any better banks in the Nordic that the company should employ? A last proposal is to calculate how big the difference actually would be if CGE&Y were able to perform interest rate netting between the Nordic countries? How large are the gains that could be obtained?

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List of references
Literature Alfred Kenyon, Currency Risk and Business Management, 1990, Basil Blackwell Ltd Claes-Gran Larsson, Cash Management fr fretag- eight edition, 1982, Studentlitteratur Derek Ross, International treasury management- third edition, 1996, Euromoney Publications Eiteman, Moffett, Stonehill, Multinational Business Finance- eight edition, 1998, AddisonWesley Publishing Company Elmr, Jacobsson, Lundin, Internationell finansiering & valutor- second edition, 1992, Studentlitteratur Karin Dahmstrm, Frn datainsamling till rapport- att gra en statistisk underskning- second edition,1996, Studentlitteratur Kirt C. Butler, Multinational Finance- second edition, 2000, South-Western College Publishing Krugman, Obstfeld, International Economics: theory and policy fourth edition, 1997, Addison-Wesley Leif Hssel, Marie Norman, De finansiella marknaderna i ett internationellt perspektivsecond edition,1997, SNS Frlag Marshall, Kapner, Understanding Swaps- second edition, 1993, John Wiley & Sons Inc Robert Hudson, Treasury Management- second edition, 1994, Blackwell Finance Rolf Ejvegrd, Vetenskaplig Metod- second edition, 1996, Studentlitteratur Ross, Westerfield, Jaffe, Corporate Finance- fourth edition, 1996, Mc Graw Hill Rydin, Wiberg, Lundquist, Hkansson, Placera rtt- first edition, 1997, Liber Ekonomi Staffan Viotti, Pehr Wissn, Penningmarknaden- third edition, 1991, SNS Frlag Stefan Bennet, Finansarbetet i fretaget- second edition, 1996, Frlags AB Industrilitteratur Articles Alpha Dhanani,To hedge or not to hedge, March 2000, Management Accounting, London Eric A Bloom, More reward with less risk: Investment options for corporate treasury, Spring 2000, Afp Exchange, Bethesda

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Michael J Alfonsi, Best practices in international treasury management, Nov/ Dec 1999, Afp Exchange, Bethesda Research reports Alan V. Deardorff, One-way arbitrage and its implications for the foreign exchange marketsseminar paper No 104, 1978, University of Michigan Kaj Hedvall, Arbitrage in an experimental securities market, nr 25, 1991, Swedish School of Economics and Business Administration Helsingfors The Internet www.bof.fi www.capgemini.com www.handelsbanken.se www.nationalbanken.dk www.norges-bank.no www.om.se www.patriot.net www.rgk.se www.riksbank.se www.seb.se Interviews Anders Haller, Market Customer Support, Carina Bengtsson, Junior Dealer and Robert Lif, Senior Dealer, Ericsson Treasury Department, Telefonplan, Stockholm, 8/5 2001 Christopher Zielinsky, doctoral candidate at Sdertrns hgskola, 25/4 2001 Erik Bergsrm, Ph.D of Finance, Sdertrns hgskola, 8/5 2001 Gabriel Oxenstierna, Ph.D. of Economics, Center for Bank and Finance (CeFin) at Sdertrns hgskola, 10/4 2001 Margaretha Bussler, MBA, SAS Cash Management Department and Jan Thorberger, MBA, SAS Treasury Management Department, Stockholm, 3/5 2001 Telephone interviews Anna Bellman, Chief Information Officer at CGE&Y Sara Kihlman, Global Business Manager, Cash Management Sales SEB Scania Treasury Department SEBs Cash Management Department SEBs trading center

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SHBs Cash Management Department SHBs trading center Other sources Continuing contact and interviews with Anneli Petersson, MBA, CGE&Y economic department. Continuing contact with our advisor Curt Scheutz, Ph.D. of Finance, Sdertrns hgskola Handelsbanken NordicLink brochure- Handelsbanken, 1998, Ulla Jansson Information AB, Ljung Standard & Poors brochure- Standard & Poors, 1999, Holmgren Kommunikation AB

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Appendix A
Glossary Bonds64 - is a certificate showing that a borrower owes a specified amount of money. In order to repay the money, the borrower has agreed to make interest and principal payments on designated dates. Certificates65 - is a running promissory note placed to the holder. The interest rate is fixed during the duration. There is a highly liquid market for certificates so the certificates can be turned-over many times during its lifetime and hereby can one earn interest on interest by trading it. There are Bank, Corporate, Real estate and Community certificates. The most common certificate used throughout this thesis is; Corporate certificates which is a by law current promissory note issued by large corporations in their own names. The lifetimes are usually from one month to one year. The interest rates are fixed during the life and the yield is obtained on the date of expiration. The lowest nominal amount in Sweden is 1 million SEK. Corporations issue these certificates to cover short-term borrowing needs. Corporate certificates are impaired with a credit risk that is composed by the fact that the corporation issuing the certificate could theoretically go bankrupt making the certificate worthless. Credit risk66 - is the risk that the issuer of a security (the borrower) such as a bond defaults in its obligations and stalls payments. In case of a bankruptcy it might be revealed that the issuers assets isnt sufficient enough to fulfill either its interest payments or principal repayments. Currency risk67 - is a company exposed to if hedging is not involved. For example, if a company holds foreign currency and wants to exchange it on the spot market to an unknown exchange rate in the future, it is exposed to a currency for not knowing the exact exchange rate. It is related to expectations on the future price development. In the currency risk there is also an accounting- and tax factor that is direct related to the accounting methods the company is using when translating different debts/assets in a foreign currency as well the result- and tax consequences these get. Deposit market68 - is a part of the money market, which instruments are not securities in a formal sense, but traditional deposits and lending even though in large amounts. The life of an investment on the depositmarket varies from one day up to one year. A important caracteristic for the depositmarket is that the interest rate is negotiable and economies of scale is applicable. Foreign currency account69 - Account for other currencies than a companys domestic currency. A foreign currency account is suitable for companies with both incoming and outgoing payments in other currencies. Every currency account has different interest rates depending on the interest rate level in each specific currencys country.
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Corporate Finance, p. 102 Cash Management i Fretaget, p. 81-82, Placera rtt p. 19 66 Penningmarknaden, p. 24, 44 67 Finansarbetet i fretaget, p. 50 68 Penningmarknaden, p. 21, 30-32 69 Cash Management fr fretag, p. 125

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Forward70 - is a commitment to exchange a specified amount of one currency for a specified amount of another currency on a specified future date. It is traded over the counter arrangement between two parties that makes up a perfect match of each partys interest. Both parties are committed to the contract. Futures71 - is a highly standardized contract calling for the deferred delivery of some underlying asset, or requiring final cash settlement based on the value of the underlying asset on the contracts final settlement date. When you buy a futures contract, you buy a promise that a specified amount of foreign currency will be delivered on a specified date in the future. A forward contract between you and some other private party is an alternative way to ensure that you receive the same amount of foreign currency on the date in question. But while you have no choice about fulfilling your end of a forward deal, you can sell your forward contract on an organized future exchange, for example, if your views about future spot exchange rate were to change. Hedging72 - is done to eliminate the different monetary risks that a company is exposed to. By a hedge a company offsets all risk because it will know exactly to which exchange-and interest rate and time period an amount will be transacted. Inflation risk73 - In Sweden all bond payments are fixed in nominal terms, that is, in SEK. If inflation where to be zero percent, the income percentage would be equivalent to the interest rate on the bond. However, if the interest where to be say 4 % while inflation is 2 %, then the real income on the bond is only 4-2= 2 %. Since the future inflation rates are uncertain and the investor generally is interested in the cash flows real value, the inflation risk can become significant. Especially for bonds with cash flows fixed for a considerable future time period. Interest rate risk73 - is the most significant risk for most financial instruments available. Bond prices are directly reflected by the current interest rates. Treasury bill can serve as an example. One can say that both credit and liquidity risk is negligible for this kind of bond because the government is the issuer and there is an effective secondary market. Inflation risk exists but is quite manageable for most market actors. The dominating risk for Treasury bill is said to be interest risk. The Treasury bill is issued at a discount, below its nominal value because they have only one payment. Thats why there must be an increase in its value in order to create income. If pari, the nominal value, is 100 and the issuing price is 95, the income will be 5. This holds, of course, only under the assumption that the holder can keep the Treasury bill until expiration. If that is not the case, and the holder must sell the Treasury bill, the market might be demanding higher interest rates on its investments due to changed market conditions. This could lower the value of the Treasury bill. For an extreme example, say that the market demands 10 % on a similar Treasury bill at the time a holder needs to sell the assets. This means that one can loose money on Treasury bills. In this specific example the loss is ((95-90)/95) -5,26 %. Joint bank account74 - Is an account to which all other sub-accounts that the company possess are connected. This, of course, requires that all accounts will be in the same bank. The balance on the sub-accounts is accumulated to the joint bank account, both positive and negative. This way one can view the total balance of the company at all times. The joint bank
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Finansarbetet i fretaget, p. 152, Multinational Finance, p. 69-70, 660 Understanding Swaps, p. 17, International Economics, p. 341 72 Internationell finansiering & valutor, p. 240 73 Penningmarknaden, p. 45 74 Cash Management fr fretag, p. 76

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account is normally the only account that is interest bearing. This interest rate is negotiated with the company bank. The gain that a company gets from a joint bank account is; 1) No interest losses in transfers within the same bank 2) Lower external borrowings which results in lower interest costs 3) Lower total cash buffer through counterbalancing 4) Internal interest calculations on accounts can be made. K1 and AAA rating75 - is a relative assessment of a companys ability to, in time, meet its obligated payments and financial commitments. In other words it is a measure for how creditand trustworthy a company is. These specific classifications are supplied by the international company Standard and Poors. They provide two different rating systems, one international and one local system. In the international rating system, which focuses more on the long-term perspective, there are ten different levels and the highest rating category is AAA and the lowest is D. For the Swedish market Standard & Poors provide a local rating system called the K-classification. It has five different levels, from K-1 to K-5, and focuses on short-term credit assessment. It is called issuer credit rating and is mainly used for certificates. Organizations assessed with AAA or K1 are judged to have extremely good capabilities of meeting its financial obligations and to have the lowest degree of credit risk. The lowest rating D or K-5 indicates that an organization is in default, or is expected to be. Another wellknown rating company is Moodys Investor Service. The rating depends on the like hood that an organization will default and on the collateral afforded by the loan contract in the event of default. The ratings are constructed mainly from information supplied by the corporation, primarily the financial statements of the firm. Liquidity risk76 - If the holder of a security wishes to sell an obligation before its lifetime has terminated the holder must find a buyer. The harder and more costly it is to execute the deal, the lower is the liquidity on the security. A fully functional secondary market is a necessary premise for good liquidity. Netting77 - is to reduce the number and value of intra-group transfers made. For example, if a company owes a subsidiary USD and the subsidiary owes the parent firm EUR in equivalent values, the both transactions doesnt have to be done because they net out each other. Netting systems makes it possible to net claims and debts, so that only the net surplus/minus is invested/borrowed. The advantage of netting is that the transaction- and currency exchange costs decrease, the extent to which a company need to handle currency risks is reduced, and the planning and handling of international liquidity is rationalized. NordicLink78 - A computer software which through an Internet connection enables a company to make transfers between its accounts, that are attached to a joint bank account within the same company group, in different countries. These transactions are made in a swift and simple way at low cost and with value-date the same day. Another feature is that one person can view and have perfect access in real time to all the joint bank accounts in the current countries in the same system. Payments that are to be made in different countries can be managed in a coordinated manner from the country in which the company has its economy department. The Nordic link also possesses sophisticated security functions.

75 76

Corporate Finance, p. 559, Standard & Poors brochure Penningmarknaden, p.45-46 77 International Treasury Management, p. 73, Finansarbetet i Fretaget, p. 72 78 Handelsbanken NordicLink brochure

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Options79 - is a agreement between two parties where one of them, the option-holder, has a right, and the other, the option- issuer, has the obligation to buy or sell an underlying merchandise/asset, for example currency, at a preset price within a specified time period or on a specified date. An option can either be a put- or call option. A holder of a call option has the right but not the obligation to buy the underlying merchandise/asset. The issuer is obligated to sell the underlying merchandise/asset if the holder wishes so. A holder of a put option has the right but not the obligation to sell the underlying merchandise/asset. The issuer is obligated to buy the underlying merchandise/asset if the holder wishes so. It is therefore the holder who decides if the agreement shall pursue or not. The issuer gets compensation, a premium, from the option-holder because the issuer takes this obligation. Both parties has the opportunity to abandon their positions under the time the agreement runs (the option life time) by selling the option, to limit the loss or to secure the increase in value. Over-night investment80 - Investment of excess cash in a special bank account at an interest rate that varies from day to day. The point is that the company receives the interest yield the following morning. This implies that the companys holdings isnt locked up and by doing this procedure over and over again the company achieves compound interest effect. Different banks can offer different interest rates, so its usually lucrative for a company to shop around before settling with one offer. Even though a good bank relation may imply a higher interest rate. Pips81 - is the difference between two countries actual interest rates that are calculated over a predefined time. It is used as a nickname in connection with swap contracts. Swaps82 - is a contractual agreement evidenced by a single document in which two parties, called counter parties, agree to make a periodic payment to each other. Contained in the swap agreement is a specification of the currencies to be exchanged, the rate of interest applicable to each (which may be fixed or floating), the timetable by which the payments are to be made, and any other provisions bearing on the relationship between the parties. Swap contracts are tailor-made to meet the needs of the individual counter parties. As such, they ate created with the aid of swap specialists who serve either or both the roles of broker and market maker. As tailor-made contracts, swaps trade in an over-the-counter (OTC) type environment, as opposed to the organized exchanges on which highly standardized contracts like futures and listed options trade. Transaction risk83 - This exposure arises from exchange of one currency for another in transactions between banks. Different hedges can eliminate this risk. Translation risk84 - This exposure arises when profits, losses, assets and liabilities are expressed in one currency in terms of the base currency without an actual exchange taking place, usually for accounting purposes. Treasury bills85 - is also known as government bonds. It is a bond issued from a countrys central bank. It is a highly liquid and nearly risk-free instrument. In contrast to other short79 80

Placera rtt, p. 112 Placera rtt, p. 102, Penningmarknaden, p. 33, Internationell finansiering & valutor, p. 176 81 Internationell finansiering & valutor, p. 243, Interview with Haller at Ericsson 82 Understanding Swaps, p. 4 83 International Treasury Management, p. 15, Currency Risk and Business Management, p. 89-90, 98 84 International Treasury Management, p. 16, Currency Risk and Business Management, p. 89-90, 98-99 85 International Treasury Management, p. 286, Penningmarknaden, p. 22-23

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term securities, the Treasury bill is issued by an auction-process. In Sweden the nominal amount of a Treasury bill is most often 1, 5, 10, 50 and 100 million SEK and with a lifetime of 6 to 12 months.

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Appendix B
Interview with SAS Cash- and Treasury Management Department The SAS business concept is to serve the Scandinavian market and provide a wide choice of market-leading airline-based travel products, with special emphasis on business travel. Year 2000 SAS had a revenue of 47 500 million SEK and had 31 000 employees. Place: SAS headquarters in Frsundavik, Stockholm Date: 3 May 2001 Interviewees: Jan Torberger, SAS Treasury department and Margaretha Bussler, SAS Cash Management department Torberger opens the interview with a quote you cant beat the market and argue that interest rate arbitrage between countries are more or less impossible today because the market is refined to the extreme and is very effective. The currency market for the USD is the worlds most effective market. Everybody has access to the same information everywhere. If arbitrage opportunities where to temporarily prevail it would be because of some sort of malfunction in the technique or because of the human factor, that is, some one elses ignorance. The definition of arbitrage is a profit that demands no risk taking and that every profit is someone elses loss. If for example the banks where to offer the customers, the consumers, different prices on various instruments, the banks would trade the faulty price away and eliminate any price discrepancies very quickly. SASs short-term investments in SEK that in time differs from over-night to a couple of months are invested in the deposit market in any of the Swedish banks. For every such investment SAS shops around in order to attain the highest rate of return. Recently, but also most of the time, SAS is offered the central bank of Swedens repo rate, which currently is 4 % or just above for over-night investments. One should however consider that the over-night investments earn a compounded interest effect due to daily value date, which increases the final returns. Investments for longer time periods should yield higher returns that the effective over-night interest rate due to the fact that one accepts to tie up capital for a certain amount of time, which of course, is favorable for any recipient. SAS confirmed that they solely invest in the deposit market unless perhaps if they are given the opportunity to make fx-swaps, a description of this procedure follows below. Consequently, SAS never uses Treasury bills or corporate certificates. The reason is mainly because it is often hard to match the remaining life of the instrument with company demands. Since all the Swedish banks have a transfer deadline at 11 oclock for transfers between themselves, it is of great importance that any investment in the deposit market is done before 11 oclock. After that, there are only large sums that are allowed to be transferred and for how long time after 11 oclock that can be done is individually agreed with the bank. After a companys all possibilities to transfer money are gone, the companys bank has monopoly on any investments in the deposit market. The company places itself in a significantly poorer and clearly deteriorated bargaining position. The company will be forced to accept whatever offer the company bank gives, that is, which rate of return the bank offers, unless the company chooses to keep the money in the ordinary account at a worse rate of return. If the company contacts the bank to make inquiries after the transfer deadline has passed, the company gives 58

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itself up and reveals its intentions. This implies that the bank will probably offer a lower rate of return. The bank are, of course, very aware of this and do exploit it as often as possible. However, before the transfer deadline the banks will be forced to give accurate offers to cover their needs. The drawback for the company is that it can be difficult to know, early each day, how much money that can be invested. A suggestion is to set aside and invest as large amounts as one dares to and invest the rest later in the afternoon in the company bank to a presumably lower rate of return. Fx- swaps To exchange to another currency and invest in that currencies country with the intention to repatriate the yield means taking a risk. A risk that most companies arent willing to take. The result of the market effectiveness is that a potential profit from such an operation probably is eliminated if the transactions are hedged. Therefore, fx-swaps are a good alternative for companies with operations in several countries. The swap price is based on a simple calculation with the interest differential between the countries and has got nothing to do with market expectations. An example of how an fx-swap is useful A bank in Denmark is willing to pay a higher price, or a higher interest rate, for DKK compared to other banks on the Danish market. SAS currently hasnt got any DKK but instead they have a SEK surplus. SAS can then swap its SEK to DKK through an fx-swap in another bank and thereby isnt exposed to any currency risk. SAS can attain a better interest rate transferring the DKK to the bank with the demand for DKK, and the yield will be higher than the price for the swap. This leads to a higher rate of return in SEK than what SAS would have been able to attain in Sweden. SAS also hedges the extra returns they obtain from the Danish bank by increasing the end amount in the swap contract. SAS doesnt have to look for banks with such a demand like the one described above. SAS treasury department are an established market participant to the extent that banks that are concerned contacts SAS and makes inquiries if they are able to help them out and in return offering a high rate of return on investments. When such offers comes up SAS can via a few calculations investigate if it is more favorable than an investment in Sweden. This is, according to SAS the only way there is to profit from short-term investments in other countries without ever exchanging the money. One can think that the currency losses and profits will even out in the long run. But since all companies results are compiled on a one-year basis, most companies arent allowed to think like that. If a company exchanges money for investments in other countries without hedging it is regarded as speculation, and a company most often doesnt speculate with company assets. SAS Treasury department have access to the Reuter information system, which is very costly. They also have direct telephones to different banks that indicate for the receiver whos calling. This speeds up the phone calls and saves valuable time for both parties. SAS also uses SEBs Internet based company service that enables SAS to view their joint bank accounts in the Nordic region, updated once an hour. SAS never reveals its purpose of a bank inquiry unless they necessarily have to. The reason is simply to maintain a strong bargaining position. The bank are known to set prices to their advantage when they are aware of a customers purpose. SAS risk policy has the function of a framework, which sets the limits for whats allowed. The treasury department is obligated to keep the operations here within which defines the 59

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treasury departments scope of action. SAS doesnt have a clearly defined action plan that states how they should act under different conditions. The administrators decide by themselves how to invest and loan money. The market expectations does matter for how the administrators act. For example, it is preferable to make a longer investment in Euro if the Euro is expected to appreciate. Interest rate netting SAS utilizes interest rate netting through SEB for the Scandinavian branches. A presupposition is to employ the same bank in the countries where interest rate netting is favored. This process enables a company to net out any negative balances against positive ones. Even if the final balance still is negative SAS will only have to pay credit interest for the net negative amount, which saves a lot of money. The netting procedure also helps the centralization of the treasury department by minimizing the number of affairs SAS have to do. Even if the final netted amount is positive or negative the treasury department will only have to make one transaction to set off any negative balances, through a loan, or investing any positive balances, by lending any favored amount on the deposit market. This saves time and money for the Treasury-, Cash Management- and accounting department. One of the advantages of the deposit market, if a company is large, is that the size of the invested amount has significant impact on what interest rate of return a company can attain. Therefore, a company should be aware that the rate of return is negotiable and should be bargained at every investment occasion. An example of how interest rate netting is useful Suppose SAS wishes to invest all its temporary excess cash in Sweden. Assets in Denmark, Norway and Sweden amount to 10 million SEK in counter-value in each country. In present exchange rates 10 million SEK equals about 8 million DKK and 9 million NOK. This counter-value is dependent on which exchange rate SEB supplies in the translation between the actual currency amount and the counter-value in SEK. All together, the balances equal 30 million SEK. Suppose further that the banks fixing rates are currently at 7 % in Norway, 4 % in Sweden and 5 % in Denmark. These fixed interest rates are adjusted on a daily basis to follow SEBs internal prime rate plus the banks margin. This enables SAS to invest the total amount of 30 million in the Swedish deposit market. This means that the counter-value surpluses in the other countries are netted over to the Swedish SASs treasury department. After investment in Sweden the joint bank accounts in Norway and Denmark will have a zero balance while the Swedish joint bank account goes from +10 million to -20 million SEK without any actual transfer between the countries taking place. The Swedish SAS account receives the surplus interest rate differentials between Sweden and the other countries, that is, (7-4 %) 3 % for Norway and (5-4 %) 1 % for Denmark. The Swedish SAS account also receives 4 % interest for the originally positive 10 million SEK balance but must consequently pay 4 % interest for the negative 20 million SEK balance that occurs after the netting procedure is performed and the money is invested in the Swedish deposit market. Important to note is that this investment can be made in any Swedish bank, not just in SEB. For another way of describing how the interest is divided in SAS interest rate netting is to split the investment of 30 million in three. On the Swedish 10 million SEK SAS receives 4 % interest, on the Norwegian 10 million SEK SAS receives 7 % and on the Danish 10 million SEK SAS receives 5 % interest. The procedure origins from the fact that arbitrage arent possible. Even if the company would execute the same procedure in Norway it would yield the same result. SAS doesnt lose 60

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interest yield by investing in Sweden, which today has a low interest rate level. According to SAS, this procedure is very rational and profitable thanks to the larger amount that provides a better bargaining position. However, SAS is not allowed to overdraw the limits on its accounts in Sweden with more than 25 million SEK, its account in Norway with more than 115 million SEK and its account in Denmark with more than 60 million SEK. SAS accumulated cash balance most often amounts from plus 2 billion SEK to minus 500 million SEK on their Swedish investment account. Of all the currencies in which SAS trades SEK and NOK are the dominating ones. On SAS Treasury department there are five persons employed full-time and six persons on the Cash Management department.

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Appendix C
Interview with Ericsson Treasury Services Ericsson is the world's leading supplier in telecommunications with the largest customer base, including the world's top 10 operators. Ericsson provides total solutions covering everything from systems and applications to mobile phones and other communications tools. Year 2000 Ericsson had a revenue of 273 600 millions SEK and had 105 000 employees. Place: Ericsson headquarters at Telefonplan, Stockholm Date: 8 May 2001 Interviewee: Anders Haller, Market Customer Support The information that Ericsson Treasury Services Stockholm, (from here on TSS), has about which business that shall be hedged is very valuable and can have an influence on the market. Even though this shouldnt be possible theoretically. TSS manages all the currency hedging for Ericssons European companies. TSS uses all financial instruments available and can help in hedging in all currencies. As a complement to TSS there is also Treasury Centers in Singapore, Dallas and on Ireland. This is to be able to cover all time zones. The office on Ireland handles primarily borrowings and investments. TSS has frameworks to follow for how much risk to take, which are well defined by its risk management department. The trading is necessary so that Ericsson can hide their intentions of acting. If an order shall be hedged and the banks perceives constant large flows of a currency in the same direction, the banks can figure out in which intentions TSS is doing business. Positions are taken partly to keep a constant focus on the market and as well to obtain a more favorable rate on the hedge. It is important to keep speculation and hedging apart. The aim for Ericssons excess cash is that it shouldnt in a wider range stand still on an account that yield low rate of return. The capital shall most favorable be out working on the market the whole time. TSS handles the short liquid with swaps and repurchased agreements. This is exclusively done through well-reputed banks under the watchword first price best price. Every single Ericsson company in Sweden is connected, with its currency accounts, to a Swedish joint bank account. The companies may borrow money internally from each others balances, a form of netting/pooling between the companies. This makes it possible that only one amount has to be borrowed or invested in USD in the end (on the joint bank account). The borrowing or investments are done by swaps or repurchase agreements. The advantage by swaps is that one eliminates the currency risk. TSS can make business with different banks; the only thing to consider is the currencys stop time. Haller states that the company is not as energetic after the banks stop times, due to that they cant transfer money between different banks anymore for that day.

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Time is important on the market in the liquid forecast. If one is out in time one has all possibilities, on the other hand; if one is late one has lost some of the possibilities. The sooner one knows how to act, the better price can one get and the longer time one has to find a bank with favorable matching interests. Ericsson mainly uses USD, SEK and Euro in its business. Haller tell us that the spot-rate can change up to 20 000 times a day. The interest rates, on the other hand, move in a much lower extension. Experienced dealers, decent bank contacts and good risk management are necessary criterions to handle trading, hedging and liquid planning in a well function way. Interviewee: Carina Bengtsson, Junior Dealer Usually, for longer time horizons, Ericsson invests in Swedish corporate certificates or Treasury bills. It is regulated in the risk policy how large part of Treasury bills the company proportionally shall have of the whole investment portfolio. Real estate certificates are not used to often. The company does not use the deposit market. According to Bengtsson the corporate certificate market differs in liquidity depending on different companies borrowing needs. Interviewee: Robert Lif, Senior Dealer Lif says that it is hard to tackle our problem in a straightforward manner. He states that insurance companies capital managements has models to use for calculations of investments in the Nordic region. Ericsson doesnt have this. He continues by saying that it is the dealers themselves that are to decide how the investments shall be done, but with a matrix as a ground with a specific duration and risk. The investments are decided upon future predicted figures as the interest rate situation, exchange rates and inflation. These values are important for deciding where, which and when the investments shall be done.

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Appendix D
Original questions to the interviews in Swedish Frgor 1.) Hur placerar ni Era verblivna likvida medel? Varfr placerar Ni p det viset? Shoppar Ni runt, bland olika banker eller dylikt? r det vrt besvret? Blir det olika avkastning beroende p beloppens storlek? I s fall; p vilka instrument? r det ngonsin frhandlingsbart (rntan)? Vad har ni fr over night rnta? r det mjligt att f en hgre avkastning utan risk p s korta placeringar? 2.) Har Ni ngon sorts bestmmelser fr hur Ni agerar beroende p marknadslget, dvs. t ex rntelge och vxlingskurser mm.? Placerar man olika beroende p olika situationer/frutsttningar? T ex nr det r hgre rnta i Norge etc. Vad pverkar Ert agerande, dvs. vilka marknadsvariabler (ECBs och RBs rntepolitik, politiskt lge i olika lnder mm.)? 3.) Hur lng r Er placeringshorisont? Hur lnga placeringar gr Ni i praktiken? Hur likvida mste dessa placeringar vara? 4.) Vad har ni fr riskpolicy? Finns det ngon skriftlig sdan? 5.) Hur mnga anstllda r det p Er Treasury avdelning? Hur mycket tid lggs p just placering av verskottslikvider? r CGE&Ys tanke att endast lgga 1 till 2 timmar per dag p detta arbete fr lite tid? Hinner man f verblick p marknaden? 6.) Vilka valutor handlar ni i? r det ngon dominerande valuta och i s fall r det ett medvetet strategiskt val? 7.) Hur fr ni lpande information om valutor, rntor, terminer, swappar? Vilka banker anvnder ni? Huvudbank? Vad franledde/avgjorde valet av bank? Jobbar ni med system som NordicLink86 eller motsvarande? Bra & dliga erfarenheter? Finns det mer effektiva system? 8.) Vad skulle det vara fr frdel fr Er att placera allt i Sverige?, i det land som har hgst rntelge, samt i respektive land (aldrig flytta pengarna)? Vad ser ni att det finns fr risker med ovan nmnda alternativ? 9.) r det aktuellt att placera i en helt annan marknad, t ex USA? Varfr, varfr inte? Knner Ni till ngra andra alternativ?

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Appendix E
Original translated questions to the interviews Questions 1.) How do you invest your excess liquid cash? Why do you invest it in that way? Do you shop around, among different banks or so? Is it worth it? Do you get different yield due to the size of the amount? On which instruments, in that case? Is it ever negotiable (the yield)? What is your over night interest rate? Is it possible to get a higher yield without any risk on such a short-term investment? 2.) Do you have any regulations on how to act dependent on the market situation, that is, for example interest rate situation and exchange rates etc? Do one invest different dependent on different situations/conditions? For example when it is a higher interest rate in Norway etc. What affect your acting, that is which market variables (ECBs and RBs interest rate politic, political conditions in different countries etc). 3.) How long investment horizon do you have? How long investments do you do in the practice? How liquid does this cash need to be? 4.)What risk policy do you have? Is there a written one? 5.) How many employees are there on your Treasury department? How much time is spent on only excess cash investment? Is CGE&Ys thought to only use 1 to 2 hours per day on this work to little time? Does one get an overview of the market? 6.) What currencies do you trade? Is there any dominating currency and in that case is it a conscious strategic choice? 7.) How do you get current information about currencies, interest rates, forwards, swaps? Which banks do you use? Main bank? What gave rise to/declared the choice of bank? Do you work with systems like the Nordic Link87 or equivalent? Good & bad experiences? Are there more effective systems? 8.) What advantages would it give you to invest everything in Sweden, in the country with highest interest rate or in each country (never move the money)? What risks do you see in stated alternatives? 9.) Is it appropriate to invest in a totally different market, for example the USA? Why, why not? Do you see any other alternatives?

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SHBs Internet based system for bringing joint bank accounts together.

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Appendix F
Original instructions in Swedish to the calculation experiment Instruktioner till rkneexperimentet Fr att det skall bli s realistiska resultat som mjligt skulle vi vilja att du nmner att du ringer frn CGE&Y som om det r en verklig affr som skall gras. (Dvs. inte avslja i vilket syfte du egentligen ringer). Du skall frga hur de stller kurser angivna nedan! Om det r ndvndigt kan du nmna att beloppet rr sig om motsvarande c:a 100 miljoner SEK. Om de frhr sig om dina avsikter, dvs om du vill kpa eller slja, avbj d att besvara frgan! Detta r viktigt, att se till att banken inte vet om det r en placering eller upplning som skall gras, fr att de skall ge s frmnliga kurser och rntor som mjligt. Annars finns det risk att de stller kurserna till sin frdel. Ring till Handelsbanken och SEB. Det mste ske fre klockan 11.00, helst s tidigt som mjligt, dock mste de tv samtalen ske i direkt anslutning till varandra fr att kurserna inte skall kunna hinna ndras allt fr mycket. Vi behver fr SEK/NOK: 1. Avista kp och slj kurser 2. Forward kp och slj kurser p 1 mnad Forward kp och slj kurser p 3 mnader 3. Valutaswappkurser kp och slj kurser p 1 mnad Valutaswappkurser kp och slj kurser p 3 mnader 4. In- och utlningsrnta i Sverige p 1 mnad In- och utlningsrnta i Sverige p 3 mnader 5. In- och utlningsrnta i Norge p 1 mnad In- och utlningsrnta i Norge p 3 mnader

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Appendix G
Original translated instructions to the experimental calculation Instructions to the experimental calculation To make the test as reliable as possible we would like you to say that you are calling from CGE&Y as if it is an essential transaction that shall be done. (That is, do not reveal your real purpose for calling). You shall ask how they set the rates stated below! If it is necessary you can mention that the amount is equivalent to 100 millions SEK. If they ask you about your intentions, that is if you want to buy or sell, refuse to answer the question! This is important, to make sure that the bank doesnt know if it is an investment of borrowing that shall be done, so that they can give as favorable exchange- and interest rates as possible. Otherwise there is a risk that they set the rates favorable to themselves. Call Handelsbanken and SEB. It has to be done before 11.00 oclock, preferably as early as possible, however the two calls must be in association to each other so that the rates wont be able to change to much.

We need for SEK/NOK: 1. Spot buy and sell rates 2. Forward buy and sell rates for 1 month Forward buy and sell rates for 3 months 3. Currency swap buy and sell rates for 1 month Currency swap buy and sell rates for 3 months 4. Deposit- and lending interest rates in Sweden for 1 month Deposit- and lending interest rates in Sweden for 3 months 5. Deposit- and lending interest rates in Norway for 1 month Deposit- and lending interest rates in Norway for 3 months

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