As the global business environment becomes riskier and riskier, the job of the corporate treasurer grows ever more complex. As companies nurture relationships with customers, suppliers, and employees in far-flung parts of the world, hedging currency risks becomes increasingly complicated. When volatility appears in global financial systems, mitigating interest rate risks and ensuring uninterrupted access to funding become more challenging. And as regulations on financial services and other industries continue to evolve around the globe, treasurers are tasked with staying abreast of a wide range of geopolitical developments that might affect their organization’s cash flow.
For these reasons—and many more—successful treasurers are no longer content to do their jobs in the same way they did in the past. Winners of the 18th annual Alexander Hamilton Awards in the category Cash Management & Liquidity Optimization illustrated this point. And this year’s winners in the category FX & Financial Risk Management, sponsored by Strategic Treasurer and Kyriba, take management of complex financial risks even further.
“In the last five to 10 years, the world has become a much more complex place,” says Dennis Tosh, director of global trading for Ford Motor Company. “Not only because of the financial crisis, but also because of increased capital regulations and the impact that has on the liquidity and pricing of derivatives trading.”
Prompted by concern over the rapid evolution of risks around the world, Tosh and his colleagues in Ford’s treasury function engaged the company’s global analytics team in developing a new system for monitoring the credit risk of the company’s derivatives counterparties. The resulting tool is highly sophisticated. It helps filter out the background noise of the market and isolate the events that indicate truly significant changes in a specific counterparty’s creditworthiness. The next iteration of the tool, which is currently in beta testing, takes risk monitoring even further—using this analysis of creditworthiness to recommend, on the fly, which counterparty would be the best choice for each new derivatives transaction.
Like Ford, Toyota Financial Services is navigating a landscape of evolving financial risks. As the global economy has rebounded, sales at Toyota Motor Company have grown dramatically, nearing 50 percent year-over-year for fiscal 2013. That puts pressure on the company’s funding mechanisms, which fall within the bailiwick of Toyota Financial Services. To ensure that Toyota will continue to have access to funding as it grows, Toyota Financial Services has worked to diversify its funding sources and investor base. Last year it introduced a new type of structured notes to the market. Doing so required a great deal of cross-functional coordination.
The treasury function brought together representatives from the legal departments of both Toyota Financial Services and its prospective banking partners, accounting managers, risk managers, front-office groups, and the operating team. “We had the valuation team, together with the treasury systems team, start testing the value of certain structures,” explains Sylvia Baharet, treasury strategy manager for Toyota Financial Services. “Once [a structure] was vetted and analyzed by all the different groups, we would show our parent company that all the stakeholders of the prospective note were confident with the structure and that there was enough demand for the product.” As a result of these cross-functional efforts, Toyota Financial Services introduced new securities that have improved the company’s counterparty diversification and helped ensure its ongoing access to capital.
The treasury team at Honeywell International also understands the importance of working closely with other functions—and with other companies. Jim Colby, assistant treasurer at Honeywell, encourages his staff to regularly venture outside their comfort zone. “There are a lot of projects in the company that involve different areas of finance that need someone to step up and take the lead,” he says. “I always encourage my staff to take responsibility and become the go-to person.”
That mind-set is one reason why Colby stepped up when he saw the prospective effects of the Dodd-Frank Act on derivatives end users. “There were unintended consequences of Dodd-Frank that needed to be addressed,” he says. “Somebody had to do it, and it might as well be us.” Colby collaborated with his company’s government relations and legal staff. Although he wasn’t initially comfortable with playing a high-profile role in national politics, he took his argument to Washington, D.C. He thinks the role he played in the Dodd-Frank debate reflects the evolving nature of the treasury function.
“In this day and age, as we’re becoming more global, dealing in more emerging markets, facing more regulatory oversight—and dealing with constant changes in regulations and tax laws that are different in every country—there are a lot of things that go on outside of treasury operations that affect not only the company, but also the treasury function,” Colby says. “The role of the treasurer is becoming broader by necessity. Everything’s changing, and we need to step outside of what we’ve done in the past and be a resource that is much more strategic than ever before.”
Following are the stories of the Alexander Hamilton Award-winning initiatives through which the treasury teams at Toyota, Honeywell, and Ford stretched the definition of their responsibilities, collaborating with other corporate functions to provide even greater value to their organization.
(To access an archived version of the Treasury & Risk webcast in which this year's winners describe their projects, click here.)
Continuous Innovation in Funding Tools
As the North American economy climbed out of recession over the past few years, the auto industry experienced a dramatic rebound. One major automaker, Toyota, saw its U.S. sales volume increase by 47.1 percent in fiscal 2013 over fiscal 2012. This has increased the company’s need for access to funding—a challenge that falls to Toyota Financial Services, the captive finance arm of Toyota Motor Company. “Since the early 2000s, Toyota Financial Services has more than doubled in size,” says Ted Zarrabi, director of balance sheet strategy for Toyota Financial Services. “As a growing company we look to address our funding needs across a variety of diverse markets and investors.”
Toyota Financial Services issues a good deal of commercial paper and floating-rate bonds tied to the three-month LIBOR, but the combination of ongoing growth and incoming regulations led the captive to look for alternative sources of funding. “To ensure that we’ll have continuous access to funds, we want to diversify across multiple sectors and across a broad array of different kinds of investors,” Zarrabi says. “The diversification strategy must be a two-pronged approach: financial instruments and investors. Both are equally important and provide benefits to both the company and the investors.”
As it considered its options, Toyota Financial Services looked to an instrument class that it suspended use of during the financial crisis: structured notes. “Before the crisis, Toyota was a strong issuer of structured notes,” says Sylvia Baharet, treasury strategy manager for Toyota Financial Services. “Then the market just went away. But in 2013, we saw the opportunity to come back to the market. We wanted to pick structures that would be simple enough to make investors feel comfortable and that would have enough volume in the market to make them worthwhile. We saw this as a great opportunity to serve a different type of investor.”
Toyota Financial Services already used derivatives to hedge its interest rate and foreign exchange risk. Starting in 2013, the company established a policy that requires it to post full collateral—100 percent of exposure—for every derivatives trade it engages in, and to update the calculation of required collateral on a daily basis. “Our treasury systems function, together with our valuation and risk management teams, deployed a robust companywide platform that consists of technology and experienced valuation professionals to perform the calculations supporting all our daily collateral exchanges,” Baharet says. “Now we have zero-threshold CSAs [credit support annexes] with all of our counterparties. This has reduced our counterparty risk. It’s also reduced the credit charges associated with our derivatives trades; because we’re running only 24 hours’ worth of risk, our counterparties are very willing to extend their lines of credit out the curve.”
The daily-exchange, zero-threshold CSAs are an accomplishment in which Toyota Financial Services takes pride. “Most multinational banks have been doing daily collateral for a long time, and new regulations are pushing smaller institutions in this direction as well,” Zarrabi says. “Creating this daily collateral exchange is our way of being in line with the broader banking market. A lot of captives struggle with that, and we believe we were the first to accomplish that feat.”
Because the company was already successfully using daily collateral exchanges in the derivatives trades it uses for risk management, the treasury team knew it would be able to leverage the same capabilities if it rolled out structured notes to fund its parent’s growth. Nevertheless, the team faced a number of challenges. They evaluated their banking relationships, their distribution channels, and market demand, looking for structure types that would simultaneously meet internal funding needs and prove suitable for retail and institutional investors.
The treasury team formed working groups with representatives from all the different functions that the structured notes would impact. Legal teams from both Toyota Financial Services and its prospective banking partners reviewed prospectuses and underwriting agreements. Accounting managers helped figure out the impact the notes would have on the balance sheet, and the operating team was involved because they have to be comfortable with booking and reviewing the trades. The risk management team participated, determining the potential interest-rate and counterparty risks. And front-office groups were involved because their knowledge and contacts are crucial to building relationships with the banks that issue structured notes.
Bringing together the perspectives of all these different functions enabled the treasury team to overcome two substantial challenges: first, the fact that corporate investment policy excludes some types of structured notes, and second, ensuring that the valuations team could effectively value the derivatives in the notes. “We had the valuations team, together with the treasury systems team, start testing the value of certain structures,” Baharet explains. “They would take a hypothetical trade and give it to a third party to value, then compare that with our internal valuation. They’d do that multiple times to make sure the internal systems could value the note effectively and that every single calculation was within their comfort zone. Once it was vetted and analyzed by all the different groups, we would show our parent company that all the stakeholders of the prospective note were confident with the structure and that there was enough demand for the product so that it would provide adequate counterparty diversification and enable us to raise money in different markets to meet Toyota’s funding needs.”
The treasury team settled on two types of structured notes. Step-up callable notes are bonds for which the coupon steps up incrementally just after each call date passes. Toyota Financial Services issued notes that step up after the first year, the second year, or the fifth year if not called. Then, to hedge against interest-rate risk, Toyota uses a three-month floating-rate LIBOR interest-rate swap. “The result is that our only exposure is to three-month LIBOR,” Baharet says. The company also issued floating-rate bonds with a cap. The capped floaters and step-up callable notes, which Toyota Financial Services issued over a one-year period, had a total notional value of $750 million.
The most obvious benefit of the issuance is that the company saved $29 million compared with a benchmark seven-year bond. “If we’re able to issue close to $1 billion in structured notes, rather than doing another three-year, five-year, or 10-year unsecured deal, we gain a substantial cost savings and can operate more efficiently in both markets,” Zarrabi says. “The structured notes are generally cheaper than bonds in the markets we typically issue in. On top of that, we avoid over-saturating the market, which could raise the cost of issuing our usual securities.” One more benefit of the structured note program: “For people who want credit exposure to Toyota, it gives them a vehicle to buy that,” Baharet says. “As a company, Toyota Financial Services will keep on finding different ways to diversify funding.”
Venturing Outside the Treasury Comfort Zone
When they heard about how the Dodd-Frank Act might affect their organization, most corporate treasurers and finance managers ducked their heads down and fretted. Not Jim Colby. The assistant treasurer of Honeywell International, Colby joined treasurers from a handful of other prominent companies in making his case to the powers that be. He testified before both the U.S. Senate Committee on Agriculture, Nutrition, and Forestry and the U.S. House Committee on Agriculture. He also met repeatedly with U.S. Commodity Futures Trading Commission (CFTC) and House and Senate staff members. The fact that politics was outside his comfort zone did not slow him down.
“I got involved in the debate for two reasons,” Colby says. “First, I wanted to better understand the rule-making process and to be connected to the people who were shaping the legislation and regulations. The legislation and regulations are very complicated, so it was important to Honeywell to be aware of the latest thinking on interpretations. And the second reason is that there were unintended consequences of Dodd-Frank that needed to be addressed. Somebody had to do it, and it might as well be us.”
Honeywell uses derivatives to mitigate risks in subsidiaries located around the globe. “Ninety-five percent of our derivatives transactions with banks are executed by the parent company,” Colby says. “We have a small commodities-hedging program. We use interest rate swaps to manage the interest rate risk on the parent company’s debt. And for approximately 300 wholly-owned affiliates from around the world, we net their foreign exchange [FX] exposures by currency pair and trade the net exposures with banks. So the parent company enters into transactions with the subsidiaries to hedge those exposures and we hedge the net amount externally.” As a result of this process, Honeywell reduces its external FX hedges by 75 percent, but it engages in tens of thousands of intercompany transactions each year.
Although the European Market Infrastructure Regulation (EMIR) requires the company to report daily on a large proportion of those intercompany transactions, starting to report daily to the CFTC on the remaining transactions would have been expensive. “Every time you have to report these transactions, it takes manpower and resources and IT spending,” Colby says. “If we wanted to avoid the intercompany transactions and have our subsidiaries trade directly with banks, not only would we be reducing the efficiency of our risk management activities, but we would be creating more risk in the financial system.” Honeywell participated in the successful effort to gain no-action relief for internal trades. “The CFTC no-action relief saved us quite a bit of money and freed up time that we could spend productively on other issues,” Colby says.
Then there was the issue of margin. Although FX forwards and swaps are not subject to Dodd-Frank margin requirements, Honeywell faced the prospect of having to post collateral for all the interest-rate and non-deliverable forward (NDF) FX derivatives the company uses to mitigate daily business risks. Colby estimates that Honeywell has approximately $2 billion of hedging contracts that would be defined as swaps under Dodd-Frank. Applying a 3 percent initial margin and a 10 percent variation margin to that amount would require about $250 million in margin to be posted. “That’s almost 25 percent of our annual capex budget,” Colby says. “That’s real money that would be sitting in a margin account not being productively employed in the economy, and on top of that we’d have to set aside liquidity in order to meet potential future margin calls.”
In fact, as Colby cited in his testimony to the House and Senate Committees, a survey by the Coalition for Derivatives End Users estimates that a 3 percent margin requirement could reduce capital spending among S&P 500 companies alone by up to $6.7 billion and could cost 100,000 to 130,000 jobs. “Cash deposited in a margin account cannot be productively deployed in our businesses and therefore detracts from Honeywell’s financial performance and ability to promote economic growth and protect American jobs,” Colby told the Senators and House members.
The debate on margin requirements has yet to be settled, but decision-makers are listening to Colby and the other treasurers who stepped up to represent corporate end users of derivatives. “Because we understood how the laws were going to impact what we do on a daily basis much better than a lobbyist or government relations specialist, we were in a position to influence the debate in Washington,” Colby says.
In fact, treasury is in a unique position to influence broader conversations within the company as well. “Everything that happens to the company, all the cash flow, all the investments, have to be financed by treasury. We deal with all the external financing issues, external investors, and ratings agencies, but we also deal with internal company finance issues. We understand the businesses, and we have a good underpinning in financial theory and fundamentals. That gives us a unique view of what’s going on, and it gives us a unique seat at the table.”
For many corporate treasurers, that seat may be intimidating because it’s outside of the traditional realm of responsibility for treasury. “A lot of people avoided getting involved in the discussion about the potential impact of Dodd-Frank on derivatives end users,” Colby says. “They weren’t comfortable going to Washington and testifying and possibly being quoted in the press.”
Colby acknowledges that he was fortunate to get buy-in for his participation from the senior management at Honeywell. “Our management team understands how important it is to have a voice in Washington,” he says. “When they found out that we might potentially have to post hundreds of millions of dollars in a margin account—money that we would otherwise be using to run the business—we received quick support for this initiative. There are companies where it might be more difficult to get support, but you also have to be willing to ask. You have to understand the facts of the situation, translate that into hard numbers, and get out in front of it. And, of course, it always helps for treasury to have a good relationship with government relations and legal.” In fact, Colby encourages his staff to get involved in projects that may not seem, at first blush, to fall within the scope of their role. “There are a lot of projects in the company that involve different areas of finance that need someone to step up and take the lead,” he says. “I always encourage my staff to step up and take responsibility and become the go-to person.”
Stepping outside the box of traditional treasury activities may be uncomfortable at first, but Colby believes it’s necessary. “In this day and age,” he says, “as we’re becoming more global, dealing in more emerging markets, facing more regulatory oversight—and dealing with constant changes in regulations and tax laws that are different in every country—there are a lot of things that go on outside of treasury operations that affect not only the company, but also the treasury function. The role of the treasurer is becoming broader by necessity. Everything’s changing, and we need to step outside of what we’ve done in the past and be a resource that is much more strategic than ever before.”
Counterparty Risk Management as an Art—and a Science
Like Honeywell and Toyota Financial Services, Ford Motor Company uses derivatives to mitigate risks. It uses interest rate swaps, mostly fixed-rate swaps with tenors of five years or less, to hedge the interest rate risk inherent in the balance sheet of Ford Credit Services. It uses short-term FX swaps and FX forwards to reduce the uncertainty of cash flows among business units around the world. And it uses derivatives to hedge some of the commodity exposures experienced by the auto manufacturing business.
The combination of these transactions exposes Ford to counterparty risk with about 20 different financial institutions in a variety of countries. After the financial crisis of 2008, the company re-evaluated its practices for gauging and mitigating counterparty risk in its derivatives trades. “We were monitoring our counterparties using market metrics like movement in equity price or CDS [credit default swap] spreads,” says Dennis Tosh, director of global trading for Ford. “When we saw outsized movements with a counterparty, we’d try to find news stories and drill down. But this method made it difficult to filter out the background noise.” For example, if a group of banks experienced a dramatic swing in a metric like equity price, Ford may not have been able to easily determine whether the swing resulted from an idiosyncratic issue with those particular banks, or whether it was the result of larger macroeconomic forces that were affecting all financial services firms.
“In the last five to 10 years, the world has become a much more complex place—not only because of the financial crisis, but also because of increased capital regulations and the impact that has on the liquidity and pricing of derivatives trades,” Tosh says. “The treasury team recognized the opportunity to improve our process for monitoring counterparty risk. We asked ourselves, ‘Who in the company would be in a good position to help us?’ And the obvious answer was the global analytics team.”
The global analytics team is involved in a wide range of analytical functions within Ford, ranging from business modeling to activities such as optimization of lease residuals and exploration of the correlation between used-car prices and new-car sales. Treasury had worked with the group on projects in the past, and Tosh knew some of the individuals on the team. “We knew that these folks could really help us in taking our monitoring process to a new level,” he says. “We pulled together a cross-functional team, bringing in the experts in the global analytics area. We described our business needs and had some of them sit in on our monitoring meetings to really see how our legacy process worked. They came back to us with a proposal, which we discussed and then vetted through senior leadership.”
Together, treasury and global analytics staff developed a project plan that divided the initiative into three phases. First, they constructed what Tosh calls an “early warning radar,” a hierarchical set of risk indicators that are forward-looking. “We’re looking at some of the usual metrics—things like change in equity price, bid-to-offer spread, daily trading volume, CDS spreads,” Tosh says. “We developed a hierarchy that we can drill down into. This data is automatically downloaded every day and fed into our model.”
The second phase of the project involved development of a framework that pulls all this data into a Monte Carlo simulation to calculate the credit valuation adjustment (CVA)—the market value of counterparty credit risk—at a trade, counterparty, and portfolio level. “We look at risk from a portfolio perspective to understand how the different types of risk we have with a counterparty correlate with each other,” Tosh says. “For example, how does exposure on a long euro-sterling cross-currency swap correlate to a 10-year U.S. interest-rate swap?
“Our statistical analyses help us understand what the markets are telling us about how big our exposure actually is,” Tosh adds. “We can look at whether there are issues with a particular country, which was very important during the European debt crisis. We can also determine whether there are issues with respect to a specific, individual bank. The ability to hone in on a specific counterparty and see whether the market is signaling a problem with that institution is the real value-add of the statistical evaluation process.” The CVA calculations analyze all of the 48 interest rate curves, 18 currencies, and seven commodities that Ford hedges, across all the counterparties Ford works with for each type of trade.
Ford treasury also established a process for escalating any problems that the model indicates with a specific institution. Every day at 5 o’clock, senior representatives from the treasury leadership team, treasury operations, risk management, and trading meet to jointly review a matrix of issues that the model has highlighted. “We look at the number of sigma, or standard deviations, that an indicator has moved from its statistical mean, and we look at the number of consecutive days in which it’s moved,” Tosh says. “If all of a sudden we have a move that’s five sigma or more, that’s a pretty clear indication that something is going on with that counterparty, and we will escalate that issue to the corporate treasurer on the same day. If we have a smaller move, such as a two-sigma move, we’d have to see that for several days in a row before we would escalate it to the treasurer. But there are other levels of movement that result in an issue being escalated to a lower level of management.”
Even when there’s an issue with a metric, Ford might not stop working with the counterparty. “We are a very relationship-oriented company,” Tosh says. “The relationships we have with our credit-line banks are extremely important. What this tool is intended to do is to drive a conversation through which we evaluate our options for reacting to the information. We have a predefined playbook that drives the conversation, and then that conversation is conducted in the context of the overall relationship with the institution, as well as a more senior assessment of how large we think the near-term clear and present danger is.”
In testing the model before rolling it out, Ford treasury used it to analyze data from 2008. “Hindsight is always 20/20, but this model did send some very clear signals that something was wrong at Lehman Brothers in the weeks before it filed bankruptcy,” Tosh says. “Ford had an important relationship with Lehman, so I can’t say for sure that we would have cut them off if we’d seen this, but we certainly would have been better prepared for their implosion. This test made clear that the model provides a tremendous benefit in terms of insight into the nature of the risks we’re taking.”
The third phase of the project, which is still in beta testing, leverages the automated CVA calculations generated in the second phase to recommend the optimal counterparty for each new trade, considering portfolio-level CVA and possible returns. “For each trade, it quickly models and tells us what the change will be in the counterparty’s CVA as a result of that trade,” Tosh says. “Is it risk-reducing? Is it risk-increasing? How many units of incremental risk would we get with Counterparty A vs. with Counterparty B, given the amount of portfolio risk we currently have with each institution? The beauty is that we’re able to make these kind of calculations on the fly.” Ford hasn’t finalized a trade-decision process that takes into account this information, but the tool’s recommendation “would be one very important factor, but still one among a variety of factors, that someone would evaluate in deciding which institution to award a specific trade,” he adds.
Tosh gives much of the credit for Ford’s statistical modeling tool to the global analytics team. “They have unique skills,” he says. “They understand the business issues we’re trying to address—and that isn’t always the case when you’re working with people with high quantitative skills. Our global analytics team is also very, very good at explaining the science in layman’s terms. In order to effectively use this tool, and to get management comfortable with it, we needed to very clearly understand the principles involved and why the tool’s creators chose the approach they chose. They did a very good job of explaining that in terms businesspeople were able to grasp.”
Ultimately, though, this project was driven by Ford’s visionary treasury team. “We saw these process improvements as critical to improving risk management at Ford,” Tosh says. “The treasury leadership team prioritized and championed the project, and made sure that the channels of communication were wide open between treasury and global analytics. The resulting tool is easy to use, easy to understand, and it generates immediate value to our risk management process. We’re very proud that we spearheaded this project.”