AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E2. The use of financial derivatives to hedge against forex risk

E2c. Netting 12 / 13

Syllabus E2c)

c) Advise on the use of bilateral and multilateral netting and matching as tools for minimising FOREX transactions costs and the management of market barriers to the free movement of capital and other remittances.

Netting is setting the debtors and creditors in the group resulting in the net amount either paid or received.

There are two types of netting:

  1. Bilateral Netting

    In the case of bilateral netting, only two companies are involved. 

    The lower balance is netted against the higher balance and the difference is the amount remaining to be paid.

  2. Multilateral Netting

    Multilateral netting is a more complex procedure in which the debts of more than two group companies are netted off against each other.

Example - June 2013 extract

Kenduri Co is considering whether or not to manage the foreign exchange exposure using multilateral netting from the UK, with the Sterling Pound (£) as the base currency. 

If multilateral netting is undertaken, spot mid-rates would be used.

The following cash flows are due in three months between Kenduri Co and three of its subsidiary companies. 

The subsidiary companies are Lakama Co, based in the United States (currency US$), Jaia Co, based in Canada (currency CAD) and Gochiso Co, based in Japan (currency JPY).

Owed by Owed to Amount
Kenduri Co Lakama Co US$ 4.5 million
Kenduri Co Jaia Co CAD 1.1 million
Gochiso Co Jaia Co CAD 3.2 million
Gochiso Co Lakama Co US$ 1.4 million
Jaia Co Lakama Co US$ 1.5 million
Jaia Co Kenduri Co CAD 3.4 million
Lakama Co Gochiso Co JPY 320 million
Lakama Co Kenduri Co US$ 2.1 million

Exchange rates available to Kenduri Co

US$/£1 CAD/£1 JPY/£1
spot 1.5938-1.5962 1.5690-1.5710 131.91-133.59

Required:

Calculate the impact of undertaking multilateral netting by Kenduri Co and its three subsidiary companies for the cash flows due in three months.

Solution

Based on spot mid-rates: US$1·5950/£1; CAD1·5700/£1; JPY132·75/£1

Multilateral netting involves minimising the number of transactions taking place through each country’s banks.

This would limit the fees that these banks would receive for undertaking the transactions.

It disadvantages may include:

  • The central treasury may have difficulties in exercising control that the procedure demands.

  • Subsidiary company’s result may be distorted if the base currency is weaken in the sustained period.