The introduction of the UFR was an attempt to address three problems. Firstly, as interest rates currently stand, applying the UFR has the effect of increasing rates with a maturity of 20 years or more (see figure 1). This causes the present value of long-term liabilities to fall, which means funding ratios and capital ratios rise. Secondly, the interest rate market for long maturities is assumed to be insufficiently liquid to permit a reliable market valuation, which means the value of liabilities may be very volatile.

Figure 1: Spot yield curve with UFR (red) and without UFR (blue) as of September 30, 2013

The third problem addressed by the UFR is the desire to escape the vicious circle which is created when interest rate risks are hedged. Due to demand among pension funds and insurers for swaps with long maturities, these interest rates are falling, necessitating further interest rate hedging and triggering a renewed rise in demand.

Risk management

The UFR, however, is raising questions about risk management by insurers and pension funds, who are required to use the UFR when valuing their liabilities in their regulatory reports. From a risk management perspective, however, there are important arguments against hedging interest rate risks on the basis of the UFR.

The UFR is not an economic reality: there are no instruments on the market which generate the same returns as the UFR-adjusted interest rates. Consequently, there is an imbalance between the value as reported to DNB and the available instruments on the market for managing the risks. Furthermore, the UFR is only applied to the liabilities on the balance sheet, and not to the assets. This creates a discrepancy between the economic reality of the assets and the ‘paper’ UFR reality of the liabilities. If a company’s assets and liabilities have identical interest rate profiles, the company does not run an interest rate risk; nonetheless, its UFR-based funding ratio does change in line with interest rate movements on the market. There is also greater interest rate sensitivity around the 20-year interest rate point: past this point, market interest rates are partially or entirely disregarded. Lastly, there is a political risk (which cannot be hedged) that the UFR method may be revised by the regulator – a fact underlined by recent developments.

Insurers and pension funds are compelled to keep two different sets of records: a ‘UFR report’ for the regulator and an economic version on which the interest rate risk is actually managed. Both records have their own, specific risks.

Insurers: debate and uncertainty

Understandably, the UFR has created quite a furor among insurers. In June 2013, EIOPA published the results of a survey of insurers who offer long-term guarantee products. Interestingly, EIOPA acknowledges in this publication that the UFR entails significant risks. Potentially, the UFR could mislead regulators, meaning that any action is taken too late. Moreover, the design of the UFR – specifically, the speed at which the forward rate converges towards the UFR – has long been a source of uncertainty. EIOPA advises using what is known as the ‘20+40’ convergence (whereby market interest rates are used up to and including 20 years and, 40 years later, the forward rate has converged to the UFR). Both insurers and the European Parliament, however, are pressing for a switch to a ‘20+10’ convergence.

Proponents of this shorter convergence period point to the lower sensitivity to shocks in (long-term) market interest rates, which would help stabilize the valuation of liabilities. One drawback of a short convergence period is the increased volatility of own funds. This is because the assets are discounted at market interest rates and are sensitive to changes in interest rates, whereas the liabilities are not. Moreover, the potential impact of a change in the level of the UFR is greater when the convergence period is shorter.

While the debate continues among European insurers, DNB has already compelled Dutch insurers to use the UFR. In so doing, DNB is largely taking its cue from EIOPA’s latest advice. However, there is a high risk that the convergence period will change in the definitive Solvency II legislation, meaning that, eventually, insurers will have to switch to a different UFR.

Pensions: DNB is pursuing its own course

The UFR committee
In October 2013, the UFR committee advised the Dutch cabinet to abandon the current method for pension funds, which involves a fixed UFR of 4.2%. The committee advises using the UFR as an ultimate rate, based on the average forward rates of the last 120 months, with an infinite convergence period.

The UFR will then become a moving target based on current market rates. As things currently stand, this would mean a UFR of 3.9% – which is significantly different to the current UFR.

The cabinet informed the UFR committee in a response that the recommendation of applying a moving target UFR will be implemented from 2015 onwards. This will only accentuate the contrast between Europe and the Dutch pension landscape. In addition to an economic report and the current UFR report, it will compel pension funds to also prepare an adjusted UFR report for 2015.

The situation as regards pension funds illustrates the political risk. Following criticism in Dutch academic circles about the high sensitivity affecting the 20-year forward rate, DNB adapted the rules specifically for pension funds. These funds must now continue applying the forward rate past the 20-year point (with fixed weightings) and the spot rates are averaged over the last three months.

Since then, in its advisory report, the UFR committee has proposed a completely new calculation method (see insert), which may have a big impact on funding ratios. It is not inconceivable that, if the yield curve fluctuates significantly, the UFR will yet again be changed. In addition, there are also long-term risks to be taken into account. The UFR could potentially create discrepancies between the pension entitlements of current and future pensioners.

The higher funding ratio resulting from the application of the UFR reduces the likelihood of increases in contributions and cuts to pensions at the present time – which is an advantage for current pensioners. If, however, the yield turns out lower than assumed, future pensioners will have fewer funds at their disposal. Potentially, therefore, pension rights may end up being transferred from younger to older generations.

Conclusion

The EIOPA study and the UFR committee illustrate that the introduction of the UFR has made the world of insurance more complex. In risk management terms, it has created two landscapes and it is not yet clear exactly what the UFR landscape will look like. From an economic perspective, the majority of risk managers will give priority to hedging risks. To prevent interference by the regulator, however, the UFR value must always be closely monitored. Furthermore, the impending change to the UFR method for pension funds reaffirms that the political risk is a significant, unmanageable factor.

With the introduction of AllianceLite (AL1) in 2008, SWIFT originally targeted smaller corporations with a lower volume of payment messages and a limited number of message types, with the option of connecting through the internet. The volume restrictions of AL1 proved to be a limiting factor and was among the reasons why many companies did not consider to offer a practical solution.

One of the major improvements in its successor AL2 is that volume restrictions through pricing are no longer imposed on a corporation, enlarging AL2’s potential target market to include companies with a high volume of payment messages. It is now also possible to access all message types (MTs) and all MX SWIFT message types and other services offered over SWIFTNet. These include:

• Accord for Treasury: A matching and exception handling solution for foreign exchange (FX), money market, over-the-counter (OTC) derivatives, and commodity trade confirmations.
• Sanctions Screening over SWIFT: An easy, cost effective compliance with sanctions laws.
• The Trade Services Utility: A centralised matching and workflow engine that can be used to support the timely and accurate matching of trade-related transaction data.
• Browse: A messaging service that enables secure access from a standard web browser to a service provider’s web server and SWIFTNet server application over the SWIFTsecure internet protocol (IP) network and SWIFTNet. thus removing any previous limitations of message types or services.

SWIFT has further increased the choice of connecting to SWIFTNet by adding the option of connecting over a SWIFT-managed virtual private network (VPN) or using an internet browser.

Both manual entry of payments into AL2 and automated file transfers via AutoClient are supported by AL2. Using AutoClient to transfer files is possible, but straight-through processing (STP) for payments, using AL2 together with a treasury management system (TMS) remains an issue because a hard token is needed to approve payments. SWIFT has indicated that it is working on a solution to overcome this shortcoming, by developing a ‘soft certificate’ for use with AutoClient using a VPN connection.

SWIFT Service Bureaux Services

With the introduction of SWIFT’s new qualifying criteria, it is generally expected that the SWIFT service bureau (SSB) market will enter a consolidation phase, where smaller SSBs might disappear and the distinguishing services of bigger SSBs will prove to be an important factor in retaining and attracting clients.

Services offered by SSBs range from providing a connecting service to SWIFTNet, to value-added services such as on-boarding assistance to sign-up to SWIFT, data transformation, data enrichment, integration and format translation, electronic bank account management (eBAM), compliance and anti-money laundering services and cash/balance reporting. These additional services will be unique selling points for SSBs in future, instead of only offering connectivity to SWIFTNet.

Important Considerations for Selection

The service provided by AL2 can be compared to an SSB, except that AL2 only offers a connection service to SWIFTNet and has the distinct advantage of eliminating a third party and simplifying the process. By dealing directly with SWIFT, it could be argued that it removes any security and performance questions around the capability of SSBs to deliver services that would need to be addressed during the selection process.

Among the main driving forces of the decision to choose between AL2 and an SSB solution is still the pricing, but other factors that can be a determining factor in the choice between AL2 and an SSB are IT policy and security, integration with an enterprise resource planning (ERP) or existing TMSs and additional services or support.

Pricing

Alliance Lite2 is priced using bands to determine the base licence fee and monthly subscription. Pricing is scalable, meaning the amount you pay is based on how much you actually use the service. Messages and files are charged as per standard SWIFT prices. There is an automatic band upgrade or downgrade every six months, based on the 12-month average network-based invoice (NBI).

The estimated cost of using AL2 is compared below with the estimated cost of choosing an SSB based on a low volume example of 50 FIN messages per day and 1,000 FileAct messages per day.

Comparing the cost of AL2 vs. SSB.

	Once off	Yearly	5 years
AllianceLite2	€ 10,000	€ 15,000	€ 85,000
SSB average	€ 30,000	€ 40,000	€ 230,000

The initial costs include only the basic implementation costs, but should any further assistance from SWIFT be required, this could lead to additional consulting costs of around € 1,500 per day. As an alternative, SWIFT offers a peace of mind support pact at an additional cost.

The range of the initial once-off cost for AL2 could vary from as little as € 10,000 (based on band 4 pricing) to an estimated €40,000 (based on a band 1 pricing), depending upon the expected volume of transactions, with the cost of connecting via an SSB ranging from around €25,000 to € 40,000, depending on the SSB.

Comparing the monthly costs of joining an SSB with AL2 shows a big difference. This is not surprising, as AL2 is based on the standard SWIFT message prices, while SSB pricing includes a margin. Over a five-year period this difference could lead to significant savings.

Although the pricing difference is a major consideration, it shouldn’t be seen in isolation. The compliance with IT policy and security standards can be a major deciding-factor in choosing between AL2 and an SSB.

IT Policy and Security

Ensuring that the SWIFT connection is secure is a basic requirement and one of the main concerns of IT departments. The current requirement of AL2 to make use of a hard token will not comply with the IT and security policies of many corporations and could be a deal breaker, leading to an early decision to select an SSB.

Furthermore, the use of AutoClient as a part of a requirement to automate the payment process is raising concerns in some IT departments as it is currently not possible to move an encrypted file from a TMS via AutoClient.

Integration and SSB Services Required

Another determining factor that will influence the decision between AL2 and SSBs is the availability of in-house skills with ability to implement SWIFT and also assist with other related projects. The implementation of SWIFT is seldom a standalone project, but is most likely part of a bigger project to consolidate the banking landscape, implement an in-house bank (IHB)/payment factory or improve TMS integration and straight-through processing (STP).

Having the required skills in-house would enable a corporation to conduct their own formatting and mapping of information to the required SWIFT formats using their TMS or ERP system, providing future independence from a third party. Should these skills not be available, then choosing an SSB could be an attractive option as this is one of the areas where an SSB can provide a value-added service in using the existing TMS or ERP output and translating it into the required SWIFT formats.

Choosing between AL2 and an SSB could thus imply a choice between outsourcing a part of the solution and keeping it in-house.

The Future

With AL2’s entry into the market, there is now greater choice when it comes to selecting connectivity to the SWIFT network. One can simplify the task by considering how you would use the AL2 option and then consider reasons why that would not be possible or desirable.

Currently, the recurring issue mentioned as a major reason for not selecting AL2 remains the use of hard tokens. This affects more than one of the major decision-making areas including IT security, integration and STP, and is probably the main disadvantage standing in the way of AL2 becoming an even more serious contender in the current SSB market.

With SWIFT indicating that it is working on resolving this issue in the near future, SAP’s development of its financial services network and the consolidation expected between the SSBs could set the scene for increased competition among the major players in this market. This in turn should enable treasurers to benefit from better service, performance and a more secure connection solution.

There are two important factors that have resulted in greater attention being paid to counterparty risk related to FIs in treasury. Firstly, FIs are no longer considered ‘immune’ to default. Secondly, the larger and better-rated corporates are now hoarding a day’s more cash compared to their pre-2008 crisis practice, due to restricted investment opportunities in the current economic environment, limited debt redemption and share buy-back possibilities and the desire to have financial flexibility.

Several trends can be identified regarding counterparty risk in the corporate landscape. In a corporate-to-bank relationship, counterparty risk is being increasingly assessed bilaterally. For example, the days are over when counterparty risk mitigating arrangements, such as the credit support annex (CSA) of an International Swaps and Derivative Association (ISDA) agreement, were only in favor of FIs. Nowadays, CSAs are more based on equivalence between the corporate and FI.

Measuring and Quantifying of Counterparty Risks

The magnitude of counterparty risk can be estimated according to the expected loss (EL), which is a combination of the following elements:

1. Probability of default (PD): The probability that the counterparty will default.
2. Exposure at default (EAD): The total amount of exposure on the counterparty at default. Besides the actual exposure the potential future exposure can also be taken into account. This is the maximum exposure expected to occur in the future at a certain confidence level, based on a credit-at-risk model.
3. Loss given default (LGD): Magnitude of actual loss on the exposure at default.

This methodology is also typically applied by FIs to assess counterparty risk and associated EL. The probability of default is an indicator of the credit standing of the counterparty, whereas the latter two are an indicator of the actual size of the exposure. Maximum exposure limits on the combination of the two will have to be defined in a counterparty risk management policy.

Another form of counterparty risk is settlement risk, or the risk that one party of the agreement does not deliver a security, or its value in cash, as per the agreement after the other party has already delivered the security or cash value. Whereas EAD and LGD are calculated on a net market value for derivatives, settlement risk entails risk to the entire face value of the exposure. Settlement risk can be mitigated, for example by the joining multicurrency cash settlement system Continuous Link Settlement (CLS), which settles gross transactions of both legs of trades simultaneously with immediate finality.

Counterparty Exposures

In order to be able to manage and mitigate counterparty risk effectively, treasurers require visibility over the counterparty risk. They must ensure that they measure and manage the full counterparty exposure, which means not only managing the risk on cash balances and bank deposits but also the effect of lending (the failure to lend), actual market values on outstanding derivatives and also indirect exposures.

Any counterparty risk mitigation via collateralisation of exposures, such as that negotiated in a CSA as part of the ISDA agreement and also legally enforceable netting arrangements, also has to be taken into account. Such arrangements will not change the EAD, but can reduce the LGD (note that collateralisation can reduce credit risk, but it can also give rise to an increased exposure to liquidity risk).

Also, clearing of derivative transactions through a clearing house – as is imposed for certain counterparties by the European Market Infrastructure Regulation (EMIR) – will alter counterparty risk exposure. Those cleared transactions are also typically margined. Most corporates will be exempted from central clearing because they will stay below the EMIR-defined thresholds.

It will be important to take a holistic view on counterparty risk exposures and assess the exposures on an aggregated basis across a company’s subsidiaries and treasury activities.

Assessing Probability of Default

A good starting point for monitoring the financial stability of a counterparty has traditionally been to assess the credit rating of the institutions as published by ratings agencies. Recent history has proved however that such ratings lag somewhat behind other indicators and that they do not move quickly enough in periods of significant market volatility. Since the credit rating is perceived to be somewhat more reactive they will have to be treated carefully. Market driven indicators, such as credit default swap (CDS)* spreads, are more sensitive to changes in the markets. Any changes in the perceived credit worthiness are instantly reflected in the CDS pricing. Tracking CDS spreads on FIs can give a good proxy of their credit standing.

How to use CDS spreads effectively and incorporate them into a counterparty risk management policy is, however, sometimes still unclear. Setting fixed limits on CDS values is not flexible enough when the market changes as a whole. Instead, a more dynamic approach that is based on the relative standing of an FI in the form of a ranking compared to its peers will add more value, or the trend in the CDS of a FI compared against that of its peers can give a good indication.

A combination of the credit rating and ‘normalised’ CDS spreads will give a proxy of the FI’s financial stability and the probability of default.

Counterparty Risk Management Policy

It is important to implement a clear policy to manage and monitor counterparty risk and it should, at the very least, address the following items:

• Eligible counterparties for treasury transactions, plus acceptance criteria for new counterparties – for example, to ensure consistent ISDA and credit support agreements are in place. This will also be linked to the credit commitment. Banks which provide credit support to the company will probably also demand ancillary business, so there should be a balanced relationship. While the pre-crisis trend was to rationalise the number of bank relationships, since 2008 it has moved to one of diversification. This is a trade-off between cost optimisation and risk mitigation that corporates should make.
• Eligible instruments and transactions (which can be credit standing dependent).
• Term and duration of transactions (which can be credit standing dependent).
• Variable maximum credit exposure limits based on credit standing.
• Exposure measurement – how is counterparty risk identified and quantified?
• Responsibility and accountability – at what level/who should have ultimate responsibility for managing the counterparty risk.
• Decision making to provide an overall framework for decision making by staff, including treatment of breaches etc.
• Key Performance Indicators (KPIs) – Selection of KPIs to measure and monitor performance.
• Reporting – Definition of reporting requirements and format.
• Continuous improvement – What procedures are required to keep the policy up to date?

Conclusion

To set up an effective counterparty risk management process, there are five steps to be taken as shown below; from identifying, quantifying, setting a policy to process and execute the set policy regarding counterparty risk.

Treasurers should avoid this becoming an administrative process; instead it should really be a risk management process. It will be important that counterparty risk can be monitored and reported on a continuous basis. Having real-time access to exposure and market data will be a prerequisite in order to be able to recalculate the exposures on a frequent basis. Market volatility can change exposure values rapidly.

* A credit default swap protects against default. In the event of a default the buyer will receive compensation. The spread (CDS spread) is the (insurance) premium paid for the swap.

What is hedging?

The aim of hedging is to mitigate the impact of non-controllable risks on the performance of an entity. Common risks are foreign exchange risk, interest rate risk, equity price risk, commodity price risk and credit risk.

The hedge can be executed through financial transactions. Examples in which hedging is used include:

• an entity that has a liability in a foreign currency and wants to protect itself against the change in the foreign exchange rate
• a company entering into an interest rate swap so that the floating rate of a loan becomes a fixed rate

Types of hedge accounting

There are three types of hedge accounting: fair value hedges, cash flow hedges and hedges of the net investment in a foreign operation.

• Fair Value Hedge
  The risk being hedged in a fair value hedge is a change in the fair value of an asset or a liability. For examples, changes in fair value may arise through changes in interest rates (for fixed-rate loans), foreign exchange rates, equity prices or commodity prices.
• Cash Flows Hedges
  The risk being hedged in a cash flow hedge is the exposure to variability in cash flows that is attributable to a particular risk and could affect the income statement. Volatility in future cash flows will result from changes in interest rates, exchange rates, equity prices or commodity prices.
• Hedges of net investment in a foreign operation
  An entity may have overseas subsidiaries, associates, joint ventures or branches (‘foreign operations’). It may hedge the currency risk associated with the translation of the net assets of these foreign operations into the group’s currency. IAS 39 permits hedge accounting for such a hedge of a net investment in a foreign operation.

The mismatch in the income statement recognition

Under the accounting standard IAS 39, all derivatives are recorded at fair value in the income statement. However these derivatives are often used to hedge recognized assets and liabilities, which are recorded at amortized cost or forecasted transactions that are not yet recognized on the Balance Sheet yet. The difference between the fair value measurement for the derivative and the amortized cost for the asset/liability leads to a mismatch in the timing of income statement recognition.

Hedge accounting seeks to correct this mismatch by changing the timing recognition in the income statement. Fair value hedge accounting treatment will accelerate the recognition of gains or losses on the hedged item into the P&L, whereas cash flow hedge accounting and net investment hedge accounting will defer the gains or losses on the hedge instrument.

The hedge relation

The hedge relation consists of a hedged item and a hedge instrument. A hedged item exposes the entity to the risk of changes in fair value or future cash flows that could affect the income statement currently or in the future. For example, a hedged item could be a loan in which the entity is paying a floating rate (e.g., Euribor 6 month + spread) to a counterparty.

If the hedge instrument is a derivative, it can be designated entirely or as a proportion as a hedging instrument. Even a portfolio of derivatives can be jointly designated as a hedge instrument. The hedge instrument can be a swap in which the entity is receiving a floating rate and paying a fixed rate. With this relation the entity is offsetting the floating rate payments and will only pay the fixed rate.

Criteria to qualify for hedge accounting

Hedge accounting is an exception to the usual accounting principles, thus it has to meet several criteria:

• At the start of the hedge, the hedged item and the hedging instrument has to be identified and designated.
• At the start of the hedge, the hedge relationship must be formally documented.
• At the start of the hedge, the hedge relationship must be highly effective.
• The effectiveness of the hedge relationship must be tested periodically. Ineffectiveness is allowed, provided that the hedge relationship achieves an effectiveness ratio between 80% and 125%.

Hedge effectiveness

Complying with IAS 39 requires two types of effectiveness tests:

• A prospective (forward-looking) test to see whether the hedging relationship is expected to be highly effective in future periods
• A retrospective (backward-looking) test to assess whether the hedging relationship has actually been highly effective in past periods

Both tests need to be highly effective at the start of the hedge. A prospective test is highly effective if, at the inception of the hedge relation and during the period for which the hedge relation is designated, the expected changes in fair value of cash flows are offset. Meaning that during the life of the hedge relation, the change in fair value (due to change in the market conditions) of the hedged item should be offset by the change in fair value of the hedged instrument.

A retrospective test is highly effective if the actual results of the hedge are within the range 80%-125%.

Calculation methods

IAS 39 does not specify a single method for the calculation of the effectiveness of the hedge. The method used depends on the risk management strategy. The most common methods are:

• Critical terms comparison – this method consists of comparing the critical terms (notional, term, timing, currency, and rate) of the hedging instrument with those from the hedged item. This method does not require any calculation.
• Dollar offset method – this is a quantitative method that consists of comparing the change in fair value between the hedging instrument and the hedged item. Depending on the entity risk policies, this method can be performed on a cumulative basis (from inception) or on a period-by-period basis (between two specific dates). A hedge is considered highly effective if the results are within the range 80%-125%.
• Regression analysis – this statistical method investigates the strength of the statistical relationship between the hedged item and the hedge instrument. From an accounting perspective this method proves whether or not the relationship is sufficiently effective to qualify for hedge accounting. It does not calculate the amount of ineffectiveness.

Termination of the hedge relation

A hedge relation has to be terminated going forward when any of the following occur:

• A hedge fails an effectiveness test
• The hedged item is sold or settled
• The hedging instruments are sold, terminated or exercised
• Management decides to terminate the relation
• For a hedge of a forecast transaction; the forecast transaction is no longer highly probable.

Please note that these requirements described previously may change as the IASB is currently working to replace IAS39 by IFRS9 (new qualification of hedging instruments, hedged items, hedge effectiveness…)

Conclusion

Hedge accounting is a complex process involving numerous and technical requirements with the objective to avoid temporary undesired volatility in P&L. This volatility is the result of valuation and or timing mismatch between the hedged item and the hedge instrument. If you are considering hedge accounting, we have a dedicated team on the valuation desk. We can offer advices on the calculation of the market values of the underlying risks and the hedge instruments, as well as setting up the hedge relation, preparing documentation and helping on the accounting treatment of the results.

The valuation of a CCS is quite similar to the valuation of an interest-rate swap. The CCS is valued by discounting the future cash flows for both legs at the market interest rate applicable at that time. The sum of the cash flows denoted in the foreign currency (hereafter euro) is converted with the spot rate applicable at that time. One big difference with an interest-rate swap is that a CCS always has an exchange of notional.

Looking at a CCS with a fixed-fixed structure (both legs of the swap have a fixed rate), the undiscounted cash flows are already known at the start of the deal, they are simply the product of the notional, the fixed rate and the year fraction.

The discounting of the cash flows requires a more complex method. The US dollar curve is the base of everything and is, therefore, not different from valuations of plain vanilla US dollar interest-rate swaps. Looking at a euro/US dollar CCS, the eurocurve (excluding credit spreads) is made of two parts:

• The euro interest rate curve and
• The basis spread.

This basis spread curve represents a ‘compensation’ for the changes in the forward FX rates between the two currencies used in the swap. Before the global credit crisis this spread was close to zero. Nowadays, the spread ranges from 18 basis points (bp) (10-year spread) to 40bp (one-year spread), but reached 120bp as shown by figure 1.

The big peak which is visible in the last quarter of 2008 was caused by the credit crisis (the default of Lehman Brothers and Bear Stearns, and the sale of Merrill Lynch, etc). Due to the lack of liquidity in the market during the crisis, the (liquidity) spreads in the US became a lot higher than those in Europe. To make up for this window of arbitrage, the basis spread decreased at a similar pace.

Here is an example: The characteristics of our USD-EUR example swap are:
The first leg in US dollar has a notional of USD 10,000,000 and a fixed interest of 2.50%

The valuation is performed at January 31st, 2011. The FX rate at that moment was EUR/USD 1.3697. The second leg in euro has a notional of EUR 7,481,670 and a fixed interest of 3.00%. The valuation is done from the perspective of the party which pays the euro flows and receives the US dollar flows. The frequency of the payment is annual and there is no amortization of the notional.

• In columns B and E the future cash flows are calculated by multiplying the notional with the fixed rate applicable for that leg. This results in cash flows of USD 250,000 (column B) and -/- EUR 224,450 (column E).
• The market value of the cash flows is calculated by multiplying the cash flows with their discount factor (column C for the US dollar and column F for the euro).
• The euro market value (column G) is converted to US dollar by multiplying it with the spot EUR/USD, i.e. 1.3697. Adding this converted value to the US dollar market value of column D results in the net market value (column H).

To demonstrate the impact of the basis spread we will repeat step 2 and 3 without the basis spread. The euro market value excluding basis spread is shown in column J, it is calculated by multiplying column E and I. The adjusted net market values are shown in column K. The difference of the sum of column H and K is 7,5 basis points of the US dollar notional. The basis spread impact can be checked, for the first year, by calculating the variation between the value in column G (222,206) with the value in column J (221,347), the result is 39bp which is in line with figure 1.

The above calculation shows that the exclusion of the basis spread in the valuation of the cross-currency swap results in a wrong net market value.

A credit default swap, or CDS, is effectively an insurance product whereby the consequences of a bankruptcy (default) of a reference party are transferred in return for a periodic payment. Take, for example, a party that wishes to purchase or has already purchased a bond, but is keen to avoid the (further) risk that the seller will go bankrupt. By concluding a CDS, any loss sustained in the case of default is compensated, or paid off, in return for a periodic payment; the premium for the CDS.

The CDS is valued in much the same way as its cousin, the interest rate swap. In an interest rate swap, the exchange of fixed and variable interest cash flows is valued by estimating the amount of the future cash flows in advance. These cash flows are then discounted at the market interest rate applicable at that time and added up. In the case of a CDS, two types of cash flow are also exchanged. Firstly, a series of cash flows from the risk seller to the risk buyer, including the periodic payment of the premium. These cash flows are then exchanged for a (possible) cash flow from risk buyer to risk seller in the event of a default. The periodic payment ceases immediately if that bankruptcy actually takes place.

rating transition matrix

The greatest uncertainty in valuing a CDS is the moment of bankruptcy. This is generally determined by means of probability distribution and modeled on the basis of the ‘probability of default’ (PD). This probability can be obtained in the market by combining the rating of the bond with the rating transition matrix. These ratings are prepared by rating agencies. A triple-A rating is considered to denote ‘virtually risk-free’, a D rating means that a default event has already occurred. The matrix then indicates how great the probability is that a reference party will migrate from one rating to another.

Table 1 is a fictitious example of a rating transition matrix:

In order to illustrate the valuation of the CDS, we give an example of a credit default swap with the following assumptions:

• the term is two years,
• in case of bankruptcy, the loss is equal to the entire principal,
• the reference party’s current rating is BBB,
• we take the (fictitious) rating transition matrix from table 1, and
• the premium on the CDS is 4% of the principal.

Table 2 shows the probability distribution when calculating the moment of default:

Explanation of table 2:
In year 1, the probability of default (the probability of migration from rating BBB to D) is: 5%. Taking into account this probability of default in that first year, the robability of bankruptcy in year 2 is 95%, multiplied by the following two-stage default probabilities:

• constant year 1 (BBB), followed by bankruptcy (70% x 5%),
• downgrade to CCC, followed by bankruptcy (20% x 20%), and
• upgrade to AAA, followed by bankruptcy (15% x1%).

The anticipated cash flows that are payable are equal to the premium in the first year (4) and 95% of the premium in the second year (95% x 4=3.8). The anticipated cash flows that are receivable are equal to 5% of the principal (5) in the first year and 7% of the principal in the second year (7).

Assuming an interest rate of 2% per year, the following calculations apply:

The market value of the CDS is positive because the discounted present value of the premium payments is lower than the anticipated payments in the case of bankruptcy.

The eighth and last article in this series on the weighted average cost of capital (WACC) discusses how to increase shareholder value by utilizing tax opportunities. Generally, shareholder value can be created by either:

• Increasing operational cash flows, which is similar to increasing the net operating profit ‘after-tax’ (NOPAT);
• or Reducing the ‘after-tax’ WACC.

This article starts by focusing on the relationship between the WACC and tax. Best market practice is to reflect the actual environment in which a company operates, therefore, the general WACC equation needs to be revised according to local tax regulations. We will also outline strategies for utilizing tax opportunities that can create shareholder value. A reduction in the effective tax rate and in the cash taxes paid can be achieved through a number of different techniques.

Relationship Between WACC and Tax

Within their treasury and finance activities, multinational companies could trigger a number of different taxes, such as corporate income tax, capital gains tax, value-added tax, withholding tax and stamp or capital duties. Whether one or more of these taxes will be applicable depends on country specific tax regulations. This article will mainly focus on corporate tax related to the WACC. The tax treatment for the different capital components is different. In most countries, the cost of debt is tax deductible while the cost of equity isn’t (for hybrids this depends on each case).

The corporate tax rate in the general WACC equation, discussed in the first article of this series (see Part 1: Is Estimating the WACC Like Interpreting a Piece of Art?), is applicable to debt financing. It is appropriate, however, to take into consideration the fact that several countries apply thin capitalization rules that may restrict tax deductibility of interest expenses to a maximum leverage.

Furthermore, in some countries, expenses on hybrid capital could be tax deductible as well. In this case the corporate tax rate should also be applied to hybrid financing and the WACC equation should be changed accordingly.

Finally, corporate tax regulation can also have a positive impact on the cost of equity. For example, Belgium has recently introduced a system of notional interest deduction, providing a tax deduction for the cost of equity (this is discussed further in the section below: Notional Interest Deduction in Belgium).

As a result of the factors discussed above, we believe that the ‘after-tax’ capital components in the estimation of the WACC need to be revised for country specific tax regulations.

Revised WACC Formula

In other coverage of this subject, a distinction is made between the ‘after-tax’ and ‘pre-tax’ WACC, which is illustrated by the following general formula:

WACC_PT = WACC_AT / [1 – TC]

WACC_AT : Weighted average cost of capital after-tax
WACC_PT : Weighted average cost of capital pre-tax
TC : Corporate income tax rate

In this formula the ‘after-tax’ WACC is grossed-up by the corporate tax rate to generate the ‘pre-tax’ WACC. The correct corporate tax rate for estimating the WACC is the marginal tax rate for the future! If a company is profitable for a long time into the future, then the tax rate for the company will probably be the highest marginal statutory tax rate.

However, if a company is loss making then there are no profits against which to offset the interest. The effective tax rate is therefore uncertain because of volatility in operating profits and a potential loss carry back or forward. For this reason the effective tax rate may be lower than the statutory tax rate. Consequently, it may be useful to calculate multiple historical effective tax rates for a company. The effective tax rate is calculated as the actual taxes paid divided by earnings before taxes.

Best market practice is to calculate these rates for the past five to ten years. If the past historical effective rate is lower than the marginal statutory tax rate, this may be a good reason for using that lower rate in the assumptions for estimating the WACC.

This article focuses on the impact of corporate tax on the WACC but in a different way than previously discussed before. The following formula defines the ‘after-tax’ WACC as a combination of the WACC ‘without tax advantage’ and a ‘tax advantage’ component:

WACC_AT = WACC_WTA – TA

WACC_AT : Weighted average cost of capital after-tax
WACC_WTA : Weighted average cost of capital without tax advantage
TA : Tax advantage related to interest-bearing debt, common equity and/or hybrid capital

Please note that the ‘pre-tax’ WACC is not equal to the WACC ‘without tax advantage’. The main difference is the tax adjustment in the cost of equity component in the pre-tax calculation. As a result, we prefer to state the formula in a different way, which makes it easier to reflect not only tax advantages on interestbearing debt, but also potential tax advantages on common equity or hybrid capital.

The applicable tax advantage component will be different per country, depending on local tax regulations. An application of this revised WACC formula will be further explained in a case study on notional interest deduction in Belgium.

Notional Interest Deduction in Belgium

Recently, Belgium introduced a system of notional interest deduction that provides a tax deduction for the cost of equity. The ‘after-tax’ WACC formula, as mentioned earlier, can be applied to formulate the revised WACC equation in Belgium:

WACC_AT = WACC_WTA – TA

WACC_WTA : Weighted average cost of capital without tax advantage, formulated as follows: R_D x D_M / [D_M+E_M] + R_E x E_M / [D_M+E_M] TA : Tax advantage related to interest-bearing debt and common equity, formulated as follows: TC x [R_D x D_M + R_N x E_B] / [D_M+E_M] TC : Corporate tax rate in Belgium
R_D : Cost of interest-bearing debt
R_E : Cost of common equity
R_N : Notional interest deduction
D_M : Market value of interest-bearing debt
E_M : Market value of equity
E_B : Adjusted book value of equity

The statutory corporate tax rate in Belgium is 33.99%. The revised WACC formula contains an additional tax deduction component of [RN x EB], which represents a notional interest deduction on the adjusted book value of equity. The notional interest deduction can result in an effective tax rate, for example, intercompany finance activities of around 2-6%.

The notional interest is calculated based on the annual average of the monthly published rates of the long-term Belgian government bonds (10-year OLO) of the previous year. This indicates that the real cost of equity, e.g. partly represented by distributed dividends, is not deductible but a notional risk-free component.

The adjusted book value of equity qualifies as the basis for the tax deduction. The appropriate value is calculated as the total equity in the opening balance sheet of the taxable period under Belgian GAAP, which includes retained earnings, with some adjustments to avoid double use and abuse. This indicates that the value of equity, as the basis for the tax deduction, is not the market value but is limited to an adjusted book value.

As a result, Belgium offers a beneficial tax opportunity that can result in an increase of shareholder value by reducing the ‘after-tax’ WACC. Belgium is, therefore, on the short-list for many companies seeking a tax-efficient location for their treasury and finance activities. Furthermore, the notional interest deduction enables strategies for optimizing the capital structure or developing structured finance instruments.

How to Utilize Tax Opportunities?

This article illustrates the fact that managing the ‘after-tax’ WACC is a combined strategy of minimizing the WACC ‘without tax advantages’ and, at the same time, maximizing tax advantages. A reduction in the effective tax rate and in the cash taxes paid can be achieved through a number of different techniques. Most techniques have the objective to obtain an interest deduction in one country, while the corresponding income is taxed at a lower rate in another country. This is illustrated by the following two examples.

The first example concerns a multinational company that can take advantage of a tax rate arbitrage obtained through funding an operating company from a country with a lower tax rate than the country of this operating company. For this reason, many multinational companies select a tax-efficient location for their holding or finance company and optimize their transfer prices.

Secondly, country and/or company specific hybrid capital can be structured, which would be treated differently by the country in which the borrowing company is located than it would be treated by the country in which the lending company is located. The potential advantage of this strategy is that the expense is treated as interest in the borrower’s country and is therefore deductible for tax purposes.

However, at the same time, the country in which the lender is located would treat the corresponding income either as a capital receipt, which is not taxable or it can be offset by capital losses or other items; or as dividend income, which is either exempt or covered by a credit for the foreign taxes paid. As a result, it is beneficial to optimize the capital structure and develop structured finance instruments.

There is a range of different strategies that may be used to achieve tax advantages, depending upon the particular profile of a multinational company. Choosing the strategy that will be most effective depends on a number of factors, such as the operating structure, the tax profile and the repatriation policy of a company. Whatever strategy is chosen, a number of commercial aspects will be paramount. The company will need to align its tax planning strategies with its business drivers and needs.

The following section highlights four practical strategies that illustrate how potential tax advantages and, as a consequence, an increase in shareholder value can be achieved by:

• Selecting a tax-efficient location.
• Optimizing the capital structure.
• Developing structured finance instruments.
• Optimizing transfer prices.

Selecting a tax-efficient location

Many companies have centralized their treasury and finance activities in a holding or separate finance company. Best market practice is that the holding or finance company will act as an in-house bank to all operating companies. The benefit of a finance company, in comparison to a holding, is that it is relatively easy to re-locate to a tax-efficient location. Of course, there are a number of tax issues that affect the choice of location. Selecting an appropriate jurisdiction for the holding or finance company is critical in implementing a tax-efficient group financing structure.

Before deciding to select a tax-efficient location, a number of issues must be considered. First of all, whether the group finance activities generate enough profit to merit re-locating to a low-tax jurisdiction. Secondly, re-locating activities affects the whole organization because it is required that certain activities will be carried out at the chosen location, which means that specific substance requirements, e.g. minimum number of employees, have to be met. Finally, major attention has to be paid to compliance with legal and tax regulation and a proper analysis of tax-efficient exit strategies. It is advisable to include all this information in a detailed business case to support decision-making.

When selecting an appropriate jurisdiction, several tax factors should be considered including, but not limited to, the following: The applicable taxes, the level of taxation and the availability of special group financing facilities that can reduce the effective tax rate.

• The availability of tax rulings to obtain more certainty in advance.
• Whether the jurisdiction has an expansive tax treaty network.
• Whether dividends received are subject to a participation exemption or similar exemption.
• Whether interest payments are restricted by a thin capitalization rule.
• Whether a certain controlled foreign company (CFC) rule will absorb the potential benefit of the chosen jurisdiction.

Other important factors include the financial infrastructure, the availability of skilled labor, living conditions for expatriates, logistics and communication, and the level of operating costs.

Based on the aforementioned criteria, a selection of attractive countries for locating group finance activities is listed below:

Belgium: In 2006, Belgium introduced a notional interest deduction as an alternative for the ‘Belgian Co-ordination Centres’. This regime allows taxefficient equity funding of Belgian resident companies and Belgian branches of non-resident companies. As a result, the effective tax rate may be around 2-6%.

Ireland: Ireland has introduced an attractive alternative to the previous ‘IFSC regime’ by lowering the corporate income tax rate for active trading profits to 12.5%. Several treasury and finance activities can be structured easily to generate active trading profit taxed at this low tax rate.

Switzerland: Using a Swiss finance branch structure can reduce the effective tax rate here. These structures are used by companies in Luxembourg. The benefits of this structure include low taxation at federal and cantonal level based on a favorable tax ruling – a so called tax holiday – which may reduce the effective tax rate to even less than 2%.

The Netherlands: Recently, the Netherlands proposed an optional tax regulation, the group interest box, which is a special regime for the net balance of intercompany interest within a group, taxed at a rate of 5%. This regulation should serve as a substitute for the previous ‘Dutch Finance Company’.

Optimizing the capital structure

One way to achieve tax advantages is by optimizing not only the capital structure of the holding or finance company but that of the operating companies as well. Best market practice is to take into account the following tax elements:

Thin capitalization: When a group relationship enables a company to take on higher levels of debt than a third party would lend, this is called thin capitalization. A group may decide to introduce excess debt for a number of reasons. For example, a holding or finance company may wish to extract profits tax-efficiently, or may look to increase the interest costs of an operating company to shelter taxable profits.

To restrict these situations, several countries have introduced thin capitalization rules. These rules can have a substantial impact on the deductibility of interest on intercompany loans.

Withholding tax: Interest and dividend payments can be subject to withholding tax, although in many countries dividends are exempt from withholding tax. As a result, high rates of withholding tax on interest can make traditional debt financing unattractive. However, tax treaties can reduce withholding tax. As a consequence, many companies choose a jurisdiction with a broad network of tax treaties.

Repatriation of cash: If a company has decided to centralize its group financing, then it is relevant to repatriate cash that can be used for intercompany financing. In most countries, repatriation of cash can be performed through dividends, intercompany loans or back-to-back loans. It depends on each country what will be the most tax-efficient method.

Developing structured finance instruments

Developing structured finance instruments can be interesting for funding or investment activities. Examples of structured finance instruments are:

Hybrid capital instruments: Hybrid capital combines certain elements of debt and equity. Examples are preferred equity, convertible bonds, subordinated debt and index-linked bonds. For the issuers, hybrid securities can combine the best features of both debt and equity: tax deductibility for coupon payments, reduction in the overall cost of capital and strengthening of the credit rating.

Tax sparing investment products: To encourage investments in their countries, some countries forgive all or part of the withholding taxes that would normally be paid by a company. This practice is known as tax sparing. Certain tax treaties consider spared taxes as having been paid for purposes of calculating foreign tax deductions and credits. This is, for example, the case in the tax treaty between The Netherlands with Brazil, which enables the structuring of tax-efficient investment products.

Double-dip lease constructions: A double-dip lease construction is a cross-border lease in which the different rules of the lessor’s and lessee’s countries let both parties be treated as the owner of the leased equipment for tax purposes. As a result of this, a double interest deduction is achieved, also called double dipping.

Optimizing transfer prices

Transfer pricing is generally recognized as one of the key tax issues facing multinational companies today. Transfer pricing rules are applicable on intercompany financing activities and the provision of other treasury and finance services, e.g. the operation of cash pooling arrangements or providing hedging advice.

Currently, in many countries, tax authorities require that intercompany loans have terms and conditions on an arm’s length basis and are properly documented. However, in a number of countries, it is still possible to agree on an advance tax ruling for intercompany finance conditions.

Several companies apply interest rates on intercompany loans, being the same rate as an external loan or an average rate of the borrowings of the holding or finance company. When we apply the basic condition of transfer pricing to an intercompany loan, this would require setting the interest rate of this loan equal to the rate at which the borrower could raise debt from a third party.

In certain circumstances, this may be at the same or lower rate than the holding or finance company could borrow but, in many cases, it will be higher. Therefore, whether this is a potential benefit depends on the objectives of a company. If the objective is to repatriate cash, then a higher rate may be beneficial.

Transfer pricing requires the interest rate of an intercompany loan to be backed up by third-party evidence, however, in many situations this may be difficult to obtain. Therefore, best market practice is to develop an internal credit rating model to assess the creditworthiness of operating companies.

An internal credit rating can be used to define the applicable intercompany credit spread that should be properly documented in an intercompany loan document. Furthermore, all other terms and conditions should be included in this document as well, such as, but not limited to, clauses on the definition of the benchmark interest rate, currency, repayment, default and termination.

Conclusion

This article began with a look at the relationship between the WACC and tax. Best market practice is to revise the WACC equation for local tax regulations. In addition, this article has outlined strategies for utilizing tax opportunities that can create shareholder value. A reduction in the effective tax rate, and in the cash taxes paid, can be achieved through a number of different techniques.

This eight-part series discussed the WACC from different perspectives and how shareholder value can be created by strategic decision-making in one of the following areas:

Business decisions: The type of business has, among others, a major impact on the growth potential of a company, the cyclicality of operational cash flows and the volume and profit margins of sales. This influences the WACC through the level of the unlevered beta.

Treasury and finance decisions: Activities in the area of treasury management, risk management and corporate finance can have a major impact on operational cash flows, capital structure and the WACC.

Tax decisions: Utilizing tax opportunities can create shareholder value. Potential tax advantages can be, among others, achieved by selecting a taxefficient location for treasury and finance activities, optimizing the capital structure, developing structured finance instruments and optimizing transfer prices.

Based on this overview we can conclude that the WACC is one of the most critical parameters in strategic decision-making.

This article describes the reasons behind the increased interest among corporates in using hybrid instruments to optimize their capital structure and the impact of hybrids on the WACC and shareholder value. It also takes a look at treatment by accountants, tax regulation and rating agencies.

Over €8bn of capital was raised in 2005 by corporates in Europe in the hybrid category, according to The Treasurer, April 2006. Over the past decade, it has primarily been financial institutions who have been frequent issuers of hybrids to optimize their capital structure. However, corporates are now also increasingly tapping this segment.

This growing interest can be explained both by new insights regarding the accounting and rating benefits of these instruments, as well as an increased appetite by investors who are drawn by the opportunity to make an additional yield in the current low-interest rate and credit spreads environment.

Accounting Treatment

A hybrid instrument can be structured to achieve equity treatment from an IFRS perspective. IAS 32 (Financial Instruments: Disclosure and Presentation) requires a hybrid to have optional payment for all coupons and that the instrument should have no defined economic maturity.

If the instrument is structured to achieve equity accounting, the coupon is accounted for as a ‘preferred’ dividend distribution. This way, there is no interest expense and the reported net income is not affected. Likewise, earnings per share (EPS) are unchanged as for the purposes of the EPS calculation, preferred dividends are deducted from earnings.

However, if the instrument is treated as equity there is no IAS 39 (Financial Instruments: Recognition and Measurement) hedge accounting available for any associated swaps. The resulting P&L volatility may lead issuers to choose to have the instruments structured so that they are accounted for as debt.

View of Rating Agencies

Credit rating agency Moody’s published its Tool Kit for Assessing Hybrid Securities, a framework to determine the relative debt and equity characteristics of hybrid instruments, in December 1999. Since then, the rating agency has assessed hundreds of instruments, positioning them along the debtequity continuum in baskets from A (more debtlike) to E (more equity-like). Each basket on this continuum translates into the following percentages of equity and debt for the purpose of financial ratio calculations:

To illustrate, a €100m hybrid placed by Moody’s in Basket D will result in a €75m increase in equity and a €25m increase in debt. All relevant ratios, which include either debt or equity, will be adjusted accordingly by the agency.

In February 2005, Moody’s announced its revised methodology for the category, significantly increasing the acknowledgement of the equity-like features of the instruments and rewarding higher equitycredit to structures which meet specifically required features, particularly regarding subordination, coupon deferral and permanence in the capital structure. Moody’s revision has made it possible for corporates to achieve meaningful equity-credit of 50 per cent or more, and has prompted increased corporate activity in this area.

Standard & Poor’s and Fitch Ratings have also clarified their thinking on hybrids, and the three big rating agencies are now roughly in line in their treatment of hybrid capital.

Tax Treatment

The recent flow of corporate transactions has started in Europe thanks to favourable tax legislation in several European countries that makes it easier than in the US to develop new hybrid products that both improve rating treatment and qualify as debt for tax purposes. In the UK, however, the corporate tax law contains several provisions that challenge the tax deduction on interest paid on debt with ‘excessive’ equity characteristics.

The potential to achieve a more robust tax opinion may lead issuers choosing to have the instrument structured to be accounted for as debt. In article seven of this series on the WACC, ‘Reducing the WACC by Utilizing Tax Opportunities’; more tax angles related to this topic will be covered.

Impact on the WACC and Shareholder Value

Optimizing the WACC and maximizing returns to shareholders is a top priority for corporate treasurers.

Hybrid instruments strengthen the capital base by creating a buffer between senior creditors and shareholders. Hybrid capital offers an opportunity, when correctly structured and used as a substitute for more expensive and less flexible common equity, to lower the WACC.

Hybrid issues typically price between 50 and 200 basis points over senior debt. This means that the marginal cost of funding can be significantly lower than funding achieved through traditional debt and equity funding sources. This cost-effectiveness can be illustrated with the following example.

A company wants to raise €100m of capital with half of it qualifying as equity for rating purposes. It has, simply put, two options:

1. €50m each of traditional debt and equity.
2. €100m of hybrid capital with an equity treatment by the rating agencies of 50 per cent.

We assume the following rates apply to this company:

The marginal cost of capital for option 1 (traditional capital) would be:

The marginal cost of capital for option 2 (hybrid capital) would be

Please note: this calculation assumes full tax deductibility of the hybrid instrument.

By issuing hybrid capital with 50 per cent equity treatment the company achieves a cost of capital saving of 2.4 per cent. The advantage could be bigger still with 75 per cent equity treatment. The example shows that when hybrids are applied to substitute expensive equity, they offer an opportunity to lower the WACC of the issuer.

Conclusion

Hybrids offer corporates the opportunity to strengthen or maintain their credit ratings and balance sheet ratios, while funding acquisitions, share repurchases or pension deficits.

The economics achievable in current markets are an additional driving factor in the continuing rise in the number of hybrid instruments issued by corporates.

As a non-dilutive instrument, hybrid capital is particularly suitable for issuers who have limited access to equity or have dilution concerns. Raising hybrid capital offers the opportunity to lower the marginal cost of capital and therefore increase the return to shareholders.

To return to the question in the title of this article, hybrid capital can indeed be considered cheap equity. The additional cost on top of the normal cost of senior debt does not preclude the potential overall reduction in the cost of capital.

For companies with sufficient debt capacity within their current ratings, however, raising cheaper financing (not only in terms of spreads but also in terms of upfront fees) through traditional debt markets could still be a more attractive option. Possible changes in tax regimes and rating methodologies should also be taken into account when deciding on which funding instrument to choose.

Best Practice for WACC Estimation in Emerging Markets

The prospect of emerging markets, mainly driven by high growth potential, draws the attention of a corporate in search for investment opportunities. But often there is a lack of correct appraisal of both these investment opportunities, and the risks involved with the execution of the projects.

The CFO and treasurer play a vital role in assessing the quality of the investment proposals by setting the appropriate hurdle rate for project selections, to make sure shareholder value will be created given the risks involved.

The first article in the WACC series extensively describes the components that comprise the weighted average cost of capital and how to estimate the WACC.

Part six of the WACC guide will now show methods of how to deal with, and quantify, risks and features of emerging markets when estimating the WACC for foreign investment decisions and appraisals.

Which Discount Rate to Use?

One question that a company investigating a foreign investment in an emerging market should ask is: which hurdle rate should be used? Should a separate project WACC be calculated for this operation? Or, can just the corporate WACC be applied, added with a premium or discount to compensate for different inflation levels?

There are basically three different types of discount rate:

The first method is to use the corporate WACC. Supporters in favor of using one single corporate WACC argue that a multinational company can be considered as a portfolio of multiple (global) investments and therefore each investment can be treated with the same cost of capital, which reflects the company’s total aggregated portfolio risks.

This approach acknowledges the advantage of a multinational, which is able to diversify country specific risks somewhat when volatilities in different countries are partly off-set by each other due to their low correlation. The appropriate WACC for operating in an emerging market this way is the corporate WACC adjusted for the marginal contributing effect of the operation in the emerging market (based on the specific financial and operational leverage). When calculating of the nominal WACC in the foreign currency, a compensation for the different levels of inflation between the home and foreign currency will have to be added or deducted.

The second method is to consider each investment project as a stand-alone investment and value each of them according to a local WACC that reflects the risks of the local country and project. In that respect there is one major argument that demonstrates the need to calculate an individual WACC for an emerging market – emerging markets are, to some extent, non-integrated markets (not integrated with the global market). It is therefore said to be a segmented market.

The characteristic of a segmented market is that real returns (compensated for different levels of inflation) are also determined by domestic risk factors. These are characterized by inefficiencies caused by regulatory, legal and tax barriers in emerging markets.

These inefficiencies have an impact on the cost of equity. In such a case, the company determines a local project WACC, with a local cost of equity the measure of a country’s equity risk levels for the operations in the emerging markets, rather than the corporate WACC.

The third method is a ‘middle-of-the-road’ approach, which acknowledges the need to account for the additional sovereign risk factors in the country of the investment in the WACC. This is achieved by simply adding a sovereign risk premium to the corporate WACC as a markup.

Sovereign risk represents the country risk and the credit risk of the country. Simply put, the sovereign risk premium is the difference between the yield of the risk-free triple-A rated government bond and a bond issued by the local government (with the sovereign risk embedded in it) minus the inflation differential of the two currencies involved. If local bonds are issued in US$, the inflation differential should not be deducted.

The major disadvantage of adding a sovereign risk premium is that it primarily reflects the sovereign default risk and can hence serve little to quantify the exact measure of equity risk in that country. To some extent it will cover the additional market risk premium (MRP) for an emerging market, but not the total MRP.

The preferred method out of the three presented is therefore the second method that calculates a separate cost of equity and consequently a separate local WACC for the investment in the emerging market.

How is Risk Reflected in the WACC and in Cash Flow?

We have established that the preferred discount rate requires a separate WACC to be calculated for investments in emerging markets to reflect the additional risks.

The question is, which of all these additional risk factors in emerging markets are included in the cost of equity (Re) and the cost of debt (Rd) of the WACC, and which risk factors should be reflected in the projected cash flows?

Best practice is that operational risk, which is diversifiable (non-systematic), should be accounted for in the cash flow projections. Industry and country risk, which can not be eliminated by diversification (systematic risk), should be incorporated in the WACC. The industry risk is captured in the beta of the company (adjusted for the capital structure of the company).

Typical non-systematic risks include many operational challenges associated with investments in emerging markets. Included in the cash flow will also be incremental costs associated with investments in emerging markets, like insurance costs, legal costs and costs for currency repatriation and hedging.

Typical systematic risks in an emerging market include default, political and country specific economic risks and, in case of equity investments, one will also have to account for inefficient markets.

Expected inflation should be treated separately from the aforementioned sovereign risk and market inefficiencies. Whether inflation should be taken into account depends on whether the WACC is calculated in the base currency of the company or in the local currency. In the case of the latter the inflation differential will have to be added on top of the sovereign risk premium.

It is important to mention that inflation rates should be included in the discount rate as well as in the cash flow. Numerator and denominator calculations should be based on the same inflation rates, to avoid any mismatches.

Specific Risk Adjustments in the WACC

Calculating the WACC in developed markets can be a difficult exercise, but the calculation in emerging market environments is even more challenging. As well as the different and additional risks mentioned, emerging markets are also less developed, liquid and consequently less efficient. In other words, reliable information for the determination of the WACC will be harder to obtain. The next section will discuss the specific adjustments for additional risks and uncertainties in the components that comprise the WACC, which need to be taken into account

1. Cost of equity (Re):

The first component of the WACC is the cost of equity. In developed markets the capital asset pricing model (CAPM) is mostly applied to estimate the cost of equity of an investment. But CAPM has one important underlying theoretical assumption, which is that it assumes that markets are fully integrated and efficient. However, there is evidence to conclude that emerging markets are not efficient.

For fully segmented emerging markets it can even be argued that CAPM is unsuitable for estimating the cost of equity, as the equity prices are not determined by equilibrium situations due to inefficiencies and poor liquidity. However, since there is a lack of alternative methodologies to determine Re in emerging markets, CAPM is still mostly applied. In order to make CAPM suitable for emerging markets, the following factors in CAPM should be taken with care and will have to be adjusted to represent the additional risks of the partly segmented emerging markets:

Risk-free rate (Rf):
In developed markets, the 10 year government bond is the basis for CAPM calculation. But since emerging markets have a rating below triple-A, the government bonds themselves are not risk-free and they incorporate a sovereign risk premium. Another issue, which especially exists in high inflation environments, is that long-term government bonds are usually unavailable.

Beta (β):
The β in the CAPM equation provides a quantification of the sensitivity (systematic risk) of an investment project to market movements. When a beta is unknown, it is hard to properly determine in emerging markets. Sometimes companies or industries beta’s are not calculated locally, since it is likely that betas and stock returns are less correlated due to a lack of information and market inefficiencies. But there is an alternative, namely to use the global industry β, re-levered to the company’s appropriate target leverage.

Market risk premium (MRP):
The MRP is the extra return that the stock market provides over the risk-free rate to compensate for market risk.

In developed integrated markets historically derived market risk premium is estimated to be around 5%. The problem in emerging markets is that reliable data records to determine the return rates are unavailable in many cases.

Then, once you have determined the historic risk premium based on the recorded data, you also have to question whether these records are a reliable predictor for the long-term future.

Historic averages in emerging markets are often influenced by periods of high volatility. In case that historic data series show periods of extreme volatility in premiums, a downward adjustment is recommendable. Therefore these premiums should be taken with care and the historic riskpremium should subsequently be adjusted according to the prospects. There is an alternative approach often used to determine the additional market risk premium for an emerging market.

Take the market risk premium of the developed domestic market and add the sovereign risk premium, multiplied by the ratio of the standard deviation on returns of the country’s equity market, divided by the standard deviation on the local government bond.

2. Cost of debt (Rd):

The cost of debt is the second component in the WACC. It is the marginal cost that needs to be offered to raise additional capital in the form of debt, including the issuance costs of the concerning debt. Additionally, the local capital market for debt in an emerging market will show inefficiencies, and is often regulated. Consequently, in case local debt sources are used, the actual cost of debt can be substantially different to what it would have been according to the company’s credit rating.

Reliable long-term interest rates in emerging markets are rarely available and, as a result, only short-term debt will be available as a reference. Sometimes in a high inflation environment, debt instruments are dollarized or inflation indexed.

In some emerging countries it might even be impossible to obtain debt financing. This implies that a company can only invest through equity.

The chosen capital structure in an emerging market is rarely based on a free will. Restrictions to foreign ownership and a lack of availability of debt instruments or borrowing restrictions from local banks will all have an impact on the actual capital structure.

Project Appraisals

The WACC is widely applied as the discount rate to measure the quality of investments with help of the discounted cash flow method (DCF). The WACC is the proper discount rate for discounting future cash flows into a present value.

In normal circumstances, a company must seek to make a return on its investments in excess of, or at least equal to, the WACC (or a positive net present value).

The DCF-method applied for valuations in emerging markets deviates from the same method in developed markets, as in emerging markets you also have to deal with additional risks that may affect the certainty of future cash flows. It is therefore recommended to model a scenario or sensitivity based DCF for emerging market valuations. This should explicitly incorporate the non-systematic risks involved in the operation in the emerging market.

The impact of future cash flow risk should be carefully assessed, as some risks do not apply equally to industries or companies. An example can be the depreciation or appreciation of a currency. An importing company will be impacted differently by an appreciation than an exporting company.

Apart from exchange rates, the development of other economic variables can heavily impact future cash flow. This can include inflation, GDP and interest. In order to identify the impact of these variables, one can conduct a sensitivity analysis.

Next to the systematic and the non-systematic risks discussed earlier, another important feature of emerging markets are the often high levels of inflation.

There are in principle two methods how to cope with inflation in a DCF-calculation:

1. Nominal prices method:
In this method the inflation is both accounted for in the cash flows and in the discount rate.

2. Real prices method:
This approach takes into account the financial statements in real terms and consequently discounts the cash flows in real terms against the real discount rate.

The major benefit here is that it is somewhat easier to forecast future cash flows in real terms than in nominal terms, especially in environments that face high and variable levels of inflation. It is sometimes said that when inflation levels reach double digit figures it is preferable to model the forecast on real terms. Obviously when cash flows are calculated in real terms, the discount rate should be on real terms as well to avoid a mismatch.

Exchange rates are another element that need to be taken into account in a nominal forecast. In the case of imports and exports of goods in foreign currencies, there are exchange rates involved in the valuation.

You will have to take into account that the exchange rates in your valuations are impacted by the inflation rates among other items (according to purchasing power theory), although exchange rates might only be adjusted for the interest differential in the longrun.

A single discount factor (WACC) for DCF calculation in emerging markets will lead to an over-simplistification that ignores the dynamics of an emerging market. In emerging markets, with high levels of uncertainty and variability of inflation and capital structure, it’s recommended to calculate a nominal WACC per year reflecting the developments in inflation and capital structure and risk premiums. The level of inflation applied in the WACC should also be reflected in the discounted cash flows.

Conclusions

The major distinction between developed markets and emerging markets is the increased level of risk, caused by macro economic variables, volatility and inefficiencies in capital markets and political situations. There are many different ways to incorporate and account for these additional risks.

A mark-up on the domestic corporate WACC, for the sovereign risks and inflation differential, will not be sufficient to calculate the required compensation for the additional equity risks involved. Best practice is therefore to calculate a local WACC, which not only fully reflects the company specific risks but also the equity and debt market risk of the country of investment. The different components of the WACC will have to be adjusted for the risks involved.

Since emerging markets are rapidly changing, the WACC will consequently also change over time. A point estimation of the WACC should therefore be taken with care, especially when used in DCF’s for project appraisals.
The CFO and treasurer will play an important role in the strategic process of project analysis in emerging markets, not only by quantifying the specific risks involved with investment in a particular country in the estimation of the WACC, but also by determining and quantifying the risks on the foreign cash flows.

In a perfect financial world, risk management would be irrelevant for shareholders with regard to shareholder value. Risk management would not add any value in this perfect world because each participant would have equal access to the capital markets and there would be less financial distress.

This scenario is the so-called Modigliani-Miller world in which the shareholder would be able to achieve the same value by applying their own hedging strategy because they would have access to the same information as the company and, as a result, no hedging cost.

The real financial world, however, is rarely as perfect as an academic model. Capital markets do suffer from imperfections, such as information asymmetries, agency costs, transaction costs and taxes. Because of these influences, hedging costs are lower in the case where a company hedges itself rather than when individual shareholders take the same action. It is therefore possible for a company to create shareholder value by professional corporate risk management in a way that is impossible for shareholders on their own.

Ways to Add Value with Risk Management

The objective of risk management for most corporates is to reduce the influence of external financial variables on the company’s earnings volatility (in the short term). The financial variables for which the treasurer is responsible normally include interest rates and foreign exchange rates but can also include commodity prices, inflation levels or even the outside temperature.

This article will show how risk management can add shareholder value by means of lowering the WACC by breaking down the WACC formula into the different components where the risk-free rate and market premium are taken as given (Part 1: Is Estimating the WACC Like Interpreting a Piece of Art?). In its basic form the WACC formula is:

D: Market value of interest-bearing debt
E: Market value of common equity
RD: Cost of interest-bearing debt
RE: Cost of common equity
Ô: Corporate tax rate

The article will also look at the relationship between risk management and the cost of equity, cost of debt, effective tax rate, and optimal leverage.

1. Lower the cost of equity by lowering the beta of the company

A risk reduction leads to a reduction in the required return of the shareholders. Obviously, lower required returns on equity are not value creating in their own right but when combined with the other effects on the WACC, as described below, they offer possibilities to increase shareholder value.

2. Lowering the cost of debt

The cost of debt is based on the prevailing market rates plus a company-specific credit spread.

The relationship between the cost of debt and risk management is twofold. First, with regard to interest rate risk, one of the objectives of corporate risk management is to lower the absolute interest cost.

This can be done in a tactical way by active interest rate risk management where the objective is to reduce the nominal interest expenses and thereby the cost of debt. Secondly, the outcome of active interest rate risk management affects the cost of debt of a company.

The cost of debt and especially the company-specific credit spread are determined, among other factors, by cash flow and accounting ratios. As risk management focuses on the mitigation of cash flow and earnings volatility, the ratios derived from cash flow and earnings will also be less volatile.

Lower volatility in ratios and cash flows are perceived as positive by lenders. This means that lenders will subsequently lower the credit spreads and increase borrowing possibilities for the company.

3. Lowering the effective tax rate

The value of a company increases when the tax shield related to debt exceeds the cost of financial distress that is associated with debt. A combination of annual volatility in stock returns and leverage of the company determines the expected value of the tax shield.

High financial leverage and earnings volatility will lead to lower expected values of the tax shield. As a result, the shield produces fewer profits because of a loss in time value from loss carry forwards. With risk management, a company can influence and control the annual volatility of stock returns and this allows the company to increase the expected value of the tax shield.

The relationship between the WACC and taxes will be discussed in more detail in Part 7 of this guide.

4. Increasing optimal leverage

Professional risk management increases the shareholder value of the company: it lowers the credit spread and the cost of equity, and increases the expected relative tax shield. All these factors will result in an even larger benefit of risk management, which is the possibility of increasing the leverage of the company. The combination of lower required return on equity and a lower effective cost of debt can help to provide the option for a company to increase its leverage. As shown in the first two articles of this guide, increasing leverage to an optimal point creates shareholder value.

Trend in Risk Management

An integrated, proactive and quantitative approach to risk management is the latest trend in the financial markets. Increasingly, companies make use of systems to quantify the market risks their companies face and use this information for decision-making at a strategic level.

Most risk management today is aimed, primarily, at hedging transaction exposures. Few companies actively hedge interest rate exposure and FX translation exposure and an even smaller group of companies are also hedging their total economic exposure including, for example, commodity price risk.

In order to lower the earnings volatility, companies should focus on all the financial variables influencing the earnings and profitability of the company in the mid- to long-term. Useful methods to measure and manage those risks are cash-flow-at-risk or earningsat- risk models.

Current accounting rules (IAS 39 and FAS 133), however, motivate companies to pursue a risk management strategy that is primarily aimed at short-term earnings stability and makes it more difficult to hedge economic risks in order to minimize earnings volatility. If the economic hedges do not comply with hedge accounting standards then the fair value changes of the hedges are going through the P&L of the company, resulting in increased earnings volatility. This, of course, is quite the opposite of what a company engaged in risk management wants.

Committed Capital as an ART

Form As discussed in part one of this series, companies tend to maintain a sub-optimal WACC (left on the WACC curve) with a lower than optimal leverage.

A reason for this is that they want to prevent a situation of financial distress due to unforeseen events. To avoid this, companies maintain a higher than necessary credit rating and WACC in order to prevent themselves from moving towards the ‘right side’ of the optimum level.

When a company finds itself in a position of financial distress, it is relatively difficult to get back to the optimum level. Debt, as well as equity, will be more expensive and difficult to issue in this scenario.

Alternative risk transfer (ART) products can prove to be a useful instrument in optimizing the financial structure and WACC of a company whereby the abovementioned risk of financial distress is mitigated.

ART products enable companies to transfer risk in a non-traditional way by creating new possibilities to issue capital when pre-determined events occur.

An example of an ART product is committed capital, which is an option purchased by a company to issue capital, either debt or equity, if a pre-determined outside event occurs.

Take, for example, a manufacturing company that is exposed to high fuel prices. The increased fuel price cannot be set off by its clients so the increasing prices have a direct impact on the earnings, and indirectly on the equity of the company. To avoid the possible resulting financial distress, the company can buy an option (the committed capital product) to issue equity at pre-determined prices when average fuel prices are above a defined trigger level during a certain period. By issuing the equity, the company can restore the required WACC and credit rating and prevent financial distress.

Committed capital usually involves the payment of a fee (option premium) to the capital supplier from the company seeking capital in exchange for which the capital supplier agrees to supply paid-in capital on fixed terms based on a date in the future. Committed capital is therefore a form of contingent capital with an option on paid-in capital. Because of this optional characteristic of the instrument, contingent capital can in some cases have the advantage of being an off-balance sheet type of capital.

Like all sorts of capital, committed capital comes at a cost. The cost and benefits of the product have to be carefully examined and taken into account when evaluating a move into this type of financing. When conditions are right, committed capital will have a positive effect on the company by lowering the WACC. With the developments in ART products, there is convergence in capital and risk management products.

Conclusion

Corporate risk management has a positive impact on shareholder value, which can generally be increased by reducing the WACC and/or by enlarging expected cash flows. We have seen in this article how risk management can help a company to lower their WACC by lowering the cost of equity, lowering the cost of debt, increasing the expected tax shield and unlocking the possibility for a company to increase its leverage with debt.

Furthermore, accounting regulation can motivate a company not to hedge, even though this would be desirable from an economic point of view. Finally, committed capital as a form of ART products was highlighted as an instrument for a company to increase its leverage without running the risk of moving towards the undesirable ‘right side’ of the WACC curve.