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Tuesday, 16th September 2025 |
| The growth of alternative treasury management solutions |
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| While conventional treasury management products are well established, 2005 saw a range of hitherto more alternative solutions become more commonplace. Niall O’Sullivan and Paul Harris review three evolving areas. |
The role of a corporate treasurer is to manage financial risks so as to allow their company to focus on the manufacture and delivery of its chosen product. A treasurer’s required tools are constantly changing and evolving. Products such as interest rate swaps that have only been in existence since the 1980s are now generic and along with foreign exchange spot and forward contracts, they form an integral part of the risk management armoury.
New financial contracts are continuously coming into existence. These new contracts will provide the opportunity for a company to remove previously unmanageable risks. However, this is a double-edged sword. Going forward those treasurers with an understanding of these products and their applications will have the greatest success. The following three areas are seeing increased interest:
1. Inflation and pensions
Many organisations have revenues that rise and fall with inflation. Often, their costs e.g. wages, electricity, power etc., are themselves linked to inflation. On the other hand, a number, particularly those that have a reasonably high level of debt, would have fixed costs e.g. interest payments. This can present an opportunity to use an inflation derivative to better match the revenues and outgoings of the concern. The market in inflation derivatives has grown exponentially over the last 5 years, with an estimated volume in Eurozone inflation derivatives in 2004 of over €35 billion.
Under an inflation swap, one party agrees to exchange a set of inflation-linked cashflows (i.e. cashflows that grow with inflation) in return for a set of nominal cashflows. Obvious candidates that might seek to make inflation-linked payments would include property companies, project finance companies and utilities.
On the other hand, inflation derivatives and entities seeking to receive inflation have assumed pivotal importance in pension fund risk management and liability driven investing. A defined benefit pension is a promise from a company to pay its employees a proportion of their final salary upon retirement in return for the number of years worked. Typically, upon retirement, an individual’s benefit increases in line with inflation. As a result, the liabilities of a pension scheme increase when inflation increases.
The adoption of FRS17 and the recognition in company balance sheets of pension fund deficits has catapulted this area to being one of the most current topics in balance sheet management. In addition, the experience of the last few years has been salutary, with pension fund deficits having grown at a time when the conventional asset mix of assets, bonds and cash has performed strongly.
In the recent past, we have seen the impact of FRS17 and pension fund deficits e.g.
• UK Pensions Regulator involvement in Ericsson/Marconi takeover
• Proposed Permira/WHSmith takeover and the importance of pension fund trustees
• Negative impact of Pension fund deficits on credit ratings – e.g. Thyssenkrupp AG
As liability driven investing becomes more prevalent, inflation derivatives and interest rate derivatives will be used as tools to manage the risks of large fluctuations in a pension fund liability.
2. Emissions
With the recent intergovernmental meetings in Montreal and positive soundings by the US administration, the Kyoto Protocol and Emissions allowances have moved back into the public arena. Ratification of Kyoto came last year when Russia signed up to the accord.
Since the Kyoto Protocol was signed in 1997, Europe has taken the lead in establishing a viable system to reduce emissions. Since January 2005 the European Union Emissions Trading Scheme (EUETS) has been operational with a target to reduce emissions to 8 per cent below 1990 levels.
Under the EUETS, each member state is responsible for formulating a National Allocation Plan (NAP), which allocates EU Emission Allowances (EUA) to individual companies. Responsibility for the implementation of the NAP in Ireland lies with the Environmental Protection Agency (EPA).
Under the first phase (2005-07) the targeted industries are the energy, metals and minerals sectors together with any installation with a thermal input greater than 20 megawatts. In the second phase (2008-12), individual member states can elect to include further sectors. The parameters for this phase will be formulated during 2006.
At the end of December, the company will calculate the CO2 emissions created. They will have until 31st March to have these calculations independently verified and certified. By 30th April they are obliged to surrender the requisite allowances to cover their total emissions.
Should a company exceed its allocation, it has to pay in the market to purchase the shortfall (although in the first phase, it can borrow down from the following year’s allowance). In the event that a company exceeds its allocation, it must pay a fine of €40 per tonne. To compound the problem, the following year’s allowance is reduced by the amount of the excess.
3. Property derivatives
Derivatives linked to the Halifax House Price index, or indices of other property companies, have been used by retail investors for a number of years. However, such products have limited application for institutions.
Over the past year, a market has developed for products linked to indices of commercial property. These products have typically been in the form of swaps where an investor pays a spread over interest rates in return for receiving the performance of the relevant index.
Investors, hedge funds and others have used these derivatives. Unlike direct investment, the use of these derivatives does not involve the payment of stamp duty, so they can form a useful tool for an investor that needs to get a broad exposure to commercial property for a certain period of time – particularly with cash balances in some Irish property funds at over 20 per cent. In addition, an institution that wishes to take a break from the market can do so with out incurring the legal fees and possible future replacement costs that would arise from selling the property.
Time waits for no one and the only certainty is that by the time we have got to grips with these innovations, the latest generation of financial product will have arrived to provide further employment for Maths Ph.D.s. That said, an understanding of the workings of these areas will become increasingly important over the next few years. |
Niall O’Sullivan and Paul Harris are senior dealers in the structured products team at Bank of Ireland Global Markets
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