using the Case Study: Remy Cointreau: Dept Management & Yield Curves

Analyse to the board and comment on the financial performance of Remy Cointreau based on the three specific areas as follows:

1. identification & assessment of the group interest exposures
2. market fluctuations and the forecast of the european central bank with regards to short term rate fluctuations and inflation
3. the hedging policies of the group with relevance to the futures, swaps and options

Show ideas on how successful remy cointreau has been managing their debt policies and risk management. And also enhance the analysis by examining the yield shifts over the period of your analysis

Remy Cointreau: Debt Management &Yield curves Case study Reference n 111-039-1 Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 This case was written by Laurent Estachy, Associate Professor at Euromed Management. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources. 2011, Euromed Management No part of this publication may copied, stored, transmitted, reproduced, or distributed in any form or medium whatsoever without the permission of the copyright owner case centre Distributed by The Case Centre www.thecasecentre.org All rights reserved North America t +1 781 239 5884 f +1 781 239 5885 e info.usa@thecasecentre.org Rest of the world t +44 (0)1234 750903 f +44 (0)1234 751125 e info@thecasecentre.org Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org 111-039-1 REMY COINTREAU Company description Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Rmy Cointreau is organized into three product divisions (Cognac, Champagne, Liqueurs and Spirits) that include its various brands and its own distribution network, divided into several regions (Europe, Americas and Asia & Others). The portfolio of international premium brands includes the Rmy Martin cognac, the orange liqueur Cointreau, Passoa liqueur, Metaxa brandy, Mount Gay rum and Piper-Heidsieck and Charles Heidsieck champagnes. The Company's subsidiaries include Penelop BV, Tequisco, Mount Gay Holding Ltd and Remy Cointreau USA Inc, among others. Operating in this field of business implies for the Group a high level of inventories (cognac, champagne) and as a consequence a significant amount of financial debts ranging from short to long term maturities. Learning Objectives Use of interest rate derivative product (futures, FRA, swaps, options, caps, floors...) in Ta multinational corporate context. Understand yield curve fluctuations in connection with macroeconomic indicators and monetary policy. Understand the complex interactions between corporate exposures, financial instrument used and market fluctuations Subjects covered: Corporate finance Financial risk management Derivative products Hedging policy 2 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org The Remy Cointreau Group is engaged in the production and distribution of wines and spirits. The Group, whose origins date from 1724, is the result of the merger in 1990 of the holding companies of the Hriard Dubreuil and Cointreau families that controlled E. Rmy Martin & Cie SA and Cointreau & Cie SA respectively. It is also the result of successive alliances between companies operating in the same business segment of wines and spirits. 111-039-1 Macroeconomics and international finance Monetary policy Bond market Yield curve Students will refer primarily to the group annual reports and financial information available on the Remy Cointreau Group website: http://www.remy-cointreau.com/en/publication/financial/2010/2010/ Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 1 - Identification and assessment of the group interest rate exposures Students should analyse the liability structure of the Group. They should refer to balance sheets figures for the last seven years from 2004 to 2010 and focus on financial debts from short to long term maturity. They should then make a general presentation of the associated interest rate exposure of the Group for each year (fixed-floating mix), and then assess how the firm could be affected by changes in interest rates (cash flows, earnings) 2 - Market fluctuations and \"forecast\" Considering the Euro yield curve fluctuations between 2004 and 2010, students should analyse the European Central Bank Policy during this period (short term rate fluctuations) and the market expectations regarding future growth and inflation (long term rates fluctuations) 3 - Hedging Policy Students should make a detailed presentation of the derivative products (futures, swaps and options) used by the Group during the period. They should then show how the fixed-floating interest rate mix of the Group had changed during the period and analyze the results in connection with yield curves fluctuations. 3 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Study work: General description of ECB yield curves methodology Source Ecb.com Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 111-039-1 The report should be concise and synthetic with a maximum of 30 slides. (PPT class presentation) Preliminary Readings Managing Interest Rate Risk, by Will Spinney http://www.qfinance.com/financial-risk-management-best-practice/managing-interestrate-risk 4 111-039-1 Managing Interest Rate Risk by Will Spinney http://www.qfinance.com/financial-risk-management-best-practice/managing-interestrate-risk Almost all firms are exposed to interest rate risk, but it can manifest itself in different ways. A proper response to this risk can only come following a full understanding of the context of the firm and its strategy, along with a full evaluation of the risk. Firms should generate a well thought out key performance indicator (KPI) and then apply one or more of the many tools available in the market to transfer interest rate risk. Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Major Ways That a Firm Can Be Affected Interest rate risk is the exposure of the firm to changing interest rates. It has four main dimensions: 1-Changing Cost of Interest Expense or Income Companies with debt charged at variable rates (for example, based on Libor, and also called floating rates) will be exposed to increases in interest rates, whereas companies whose borrowing costs are totally or partly fixed will be exposed to falls in interest rates. The reverse is obviously true for companies with cash term deposits. This is usually the key risk that firms consider. 2-Impact on Business Performance by a Changing Business Environment Changes in interest rates also affect businesses indirectly, through their effect on the overall business environment. In normal times, for example, construction firms enjoy a rise in business activity when interest rates fall, as investors build more when the cost of projects is lower. Conversely, some firms may benefit from high levels of activity that prompt a high interest rate response by central banks. So some firms may have a form of natural hedge against the other forms of interest rate risk, although for any one firm the effect may lead or lag actual changes in rates. 3-Impact on Pension Schemes Sponsored by the Firm Pension schemes that carry liability and investment risk for the sponsor have interest rate risk in that liabilities act in a similar way to bonds, rising in value as interest rates fall and vice versa. 4-Changing Market Values of Any Debt Outstanding 5 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Introduction 111-039-1 Although a nonfinancial firm will usually report its bonds on issue in financial statements, at substantially their face value, early redemptions must be done at the market value. This may be significantly different, as interest rates will change the value of fixed-rate debt. This risk is not commonly considered by most nonfinancial firms. Investors do expect firms to take risks, especially with regard to their core business competencies. It may be that investors expect the firm to take interest rate risk. On the other hand, investors would probably not expect a firm to breach a financial covenant because of rising interest rates. Risk Management Framework A risk management framework includes the following key stages: Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 1. Identification and assessment of risks; 2. Detailed evaluation of the highest risks; 3. Creation of a response to each risk; 4. Reporting and feedback on risks. Evaluation is crucial to the management of interest rate risk and will discover exactly how a firm might be affected, thus guiding the response to the risk. Evaluation techniques include: sensitivity analysis, modeling changes in a variable against its effect; and value at risk (VaR) analysis, based on volatilities to calculate the chances of certain outcomes. Let us look at a simple firm with earnings before interest and tax (EBIT) of 100, borrowings of 400 (all on a floating rate), an interest rate of 6% (as a base case), and a tax rate of 30%, and apply some of these techniques. Evaluation 1: Sensitivity Analysis A 1% move in interest rates has an effect of 4 (1% of 400) on the annual interest charge. This is not very helpful because there is no context for the effect. Evaluation 2: Sensitivity Analysis A table can be constructed to show the effect on earnings and interest cover (Table 1). In the table items in bold represent the base case, whereas other columns represent the sensitivities to this base case. Earnings are earnings after interest and tax. 6 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Interest Rate Risk in the Context of the Firm 111-039-1 Table 1. The effect of interest rate changes on earnings and interest cover EBIT Interest Tax Earnings Interest cover 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% 100.0 (18.0) (24.6) 57.4 5.56 100.0 (20.0) (24.0) 56.0 5.00 100.0 (22.0) (23.4) 54.6 4.55 100.0 (24.0) (22.8) 53.2 4.17 100.0 (26.0) (22.2) 51.8 3.85 100.0 (28.0) (21.6) 50.4 3.57 100.0 (30.0) (21.0) 49.0 3.33 Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 This is much more helpful, showing the effect on both earnings and interest cover. If the firm has an interest cover covenant of, say, 3.75, then the table shows a high risk of a breach, depending on how likely a rise in rates might be. Evaluation 3: Sensitivity Analysis Suppose now that EBIT displays volatility. We can construct a further table (Table 2) showing interest cover under variations in EBIT and the interest rate. Italic numerals indicate a covenant breach, and the number in bold is the base case described in Table 1. Table 2. Interest cover under variations in EBIT and interest rate 7 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Interest rate 111-039-1 A drop of 5 in EBIT and a rise of 0.5% in interest rates will cause a breach, a clear risk factor for the firm. If a relationship between EBIT and interest rates can be established, then further conclusions could be drawn. Sensitivity analysis does not show the probability of these changes, but if they are availablefor example from a study of market volatilitya probability distribution for a covenant breach can easily be obtained. Suppose that investigation of the assets and liabilities in the firm's pension scheme shows that the scheme has a deficit of 50. As an illustration, VaR might tell us that, based on the volatility of the long-term interest rates used to calculate liabilities, and taking into account that the scheme has some bond investments (in which value moves are opposite to liabilities), there is a 1 in 20 chance that the deficit will increase in the next year, because of interest rate changes alone, by 15 or more. Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Interest rate risk inside a pension scheme (or other scheme for future employee benefits) often dwarfs interest rate risk inside the firm. Evaluation should reveal where a firm is sensitive to interest rates. It could be: 1. Earnings, perhaps where earnings per share (EPS) is an important issue. 2. Cash flow. 3. Interest cover ratios, perhaps because of financial covenants. 4. Other ratios, such as those used by credit rating agencies. Establishing a KPI and Response to the Risk Evaluation should lead the firm to establish a key performance indicator (KPI) for interest rate risk. A good example of a KPI would be: Interest cover to be greater than 3.75, on a 99% confidence basis, over an 18-month period. This is better than using a simple interest cover ratio or a fixed/floating ratio as a KPI, because it speaks specifically about the risk to the firm. The KPI should guide the response to the risk. Possible responses include: Avoid: It is hard to avoid interest rate risk. Accept: Simply accept the risk and take no further action. This may be suitable if there are no significant issues such as proximate financial covenants. Accept and reduce: It may be possible to reduce the risk through internal actions, such as reducing cash balances as far as possible to repay debt. 8 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Evaluation 4: VaR 111-039-1 Accept and transfer: Many market products are available that enable a firm to change the character of interest payments. This process is called hedging. Establishing a Policy The factors we have seen should be formalized in a policy, as should approaches to all risks. The policy should set out: 1. The overall direction of the policy. 3. Who has responsibility for the risk management. 4. What procedures should be in place to control the risk? 5. A framework for decision-making. 6. The key performance indicator. 7. A reporting mechanism to view the performance of the policy. Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Tools Available to Transfer Interest Rate Risk There are a large number of tools available for the transfer of interest rate risk (Table 3). 9 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org 2. How the risk is to be measured. 111-039-1 Tool Description Comment Forward rate agreement (FRA) An FRA is a tool for fixing future interest rates (or unfixing them) over shorter periods, up to say 1-2 years A 3v6 FRA allows a firm to fix the three-month Libor (or other reference) rate in three months time. It is dealt over the counter (with banks) Future Futures have the same function as FRAs. Futures are traded on an exchange, and thus have less flexibility. Cap A cap is an option instrument. The buyer of a cap pays a maximum interest rate over the life of the cap but enjoys lower rates as they come down. Caps have a premium. Caps are usually dealt over the counter by firms, and the classic use is for a borrower to buy a cap that is higher than current interest rates, thus providing insurance for the borrower. Floor A floor is an option instrument. The buyer of a floor receives a minimum interest rate over the life of the floor but enjoys higher rates as they increase. Floors have a premium. Floors are usually dealt over the counter by firms, and the classic use is for a depositor to buy a floor that is lower than current interest rates, thus providing insurance for the depositor. Collar A collar is a combination of a cap and a floor, thus providing a firm with a corridor of possible interest rates between a maximum and a minimum. A borrower would buy a cap and sell a floor, usually over the counter, thus creating a \"collar,\" or corridor, of rates. Interest rate swap An interest rate swap is probably the most widely used and popular risk transfer instrument in the field of interest rate risk. It changes the nature of a stream of interest payments from floating to fixed or vice versa. Swaps (as they are usually called) are dealt over the counter and the market is large and (usually) deep. Terms of 5 to 7 years are common with nonfinancial firms, although terms of 30 or more years are often used by pension schemes, reflecting their different maturity 10 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Table 3. Tools that can be used to transfer interest rate risk 111-039-1 horizon. A swaption is an instrument where the buyer of a swaption has the right to enter into an interest rate swap at a particular rate, thus protecting the buyer against adverse movements in long-term rates, while allowing him to benefit from favorable moves. Swaptions are not very popular with nonfinancial firms but might be used near the time of bond issues, for example. Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Interest Rate Swap This key instrument deserves a little more explanation. It is an instrument that, in its usual form, transforms one kind of interest stream to another, such as floating to fixed or fixed to floating. Each swap has two counterparties, and therefore in each swap one party pays fixed and receives floating, while the other party receives fixed and pays floating. There are two classic uses of swaps by nonfinancial firms: A floating-rate borrower converts to a fixed rate. In this case a borrower has floating-rate bank debt and carries out a pay-fixed swap, converting the debt to a fixed rate. This is shown diagrammatically in Figure 1. The two floating-rate streams cancel each other out for the borrower, leaving it to pay only a fixed-rate stream. Figure1. Floating-rate borrower uses swap to convert to a fixed rate 11 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Swaption 111-039-1 Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Figure 2. Fixed-rate borrower uses swap to convert to a floating rate Let's suppose that our firm from above has responded to the risk of covenant breach by deciding to enter into a pay-fixed swap for 75% of its borrowing. It will pay 6% on the fixed-rate leg of the swap. The interest cover table we considered in Table 2 is now as shown in Table 4. Table 4. Interest cover under variations in EBIT and interest rate for firm that pays fixed swap (see text for details) 12 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org A fixed-rate borrower converts to a floating rate. In this case a borrower has fixed-rate bond debt and undertakes a receive-fixed swap, converting the debt to a floating rate (Figure 2). The two fixed-rate streams cancel each other out for the borrower, leaving it to pay only a floating-rate stream. 111-039-1 The italicized cells (covenant breach) now cover the width of the table but are less deep. Our firm has a lower risk of a breach from interest rates alone but has increased the risk from a falling EBIT. As interest rates are believed to be more volatile than EBIT, the overall risk to our firm has been reduced through the transfer of risk. There is a key difference between interest-rate-fixing products (such as swaps) and options. A fixing instrument binds its user to the rate that is set when it is transacted. An option allows the buyer to walk away. So a firm taking out a pay-fixed swap, following which rates decline, is left paying the higher rates. The risk is thus transformed, rather than transferred. Exposure to rising rates has become an exposure to falling rates. Firms must be clear about this when establishing their response to risk. Accordingly, option products may seem to be an ideal product to deal with interest rate risk, and for those prepared to pay, they can be. However, costs rise with two main factors: Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Time: The longer an option has until expiry, the higher the premium. Volatility: The higher the volatility in the underlying risk being hedged, the higher the premium. Both these factors tend to deter firms from using options, and for the longer-term risk transfer-response interest rate swaps are usually the instrument of choice. Conclusion The effects of changes in interest rates on a firm can be complex, but techniques are available to evaluate and respond to any risks this presents. A clear reference back to business and financial strategy will put interest rate risk in its context, allow a suitable response, and help the firm to achieve its goals. Further Readings HULL John C. (2005) Options, Futures and Other Derivatives Publisher: Prentice Hall; Edition ISBN-10: 0131499084 ISBN-13: 978-0131499089 13 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Fixing Products versus Options 111-039-1 YIELD CURVE Source: http://www.ecb.int/stats/money/yc/html/index.en.html Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 A yield curve (which is known as the term structure of interest rates) represents the relationship between market remuneration (interest) rates and the remaining time to maturity of debt securities. The information content of a yield curve reflects the asset pricing process on financial markets. When buying and selling bonds, investor include their expectations of future inflation, real interest rates and their assessment of risks. An investor calculates the price of a bond by discounting the expected future cash flows. The ECB estimates zero-coupon yield curves for the euro area and derives forward and par yield curves. A zero coupon bond is a bond that pays no coupon and is sold at a discount from its face value. The zero coupon curve represents the yield to maturity of hypothetical zero coupon bonds, since they are not directly observable in the market for a wide range of maturities. They must therefore be estimated from existing zero coupon bonds and fixed coupon bond prices or yields. The forward curve shows the short-term (instantaneous) interest rate for future periods implied in the yield curve. The par yield reflects hypothetical yields, namely the interest rates the bonds would have yielded had they been priced at par (i.e. at 100). 14 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org General description of ECB yield curves methodology Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org 111-039-1 15 Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F295625 Purchased for use on the Master of Business Administration, at International Professional Managers Association (IPMA). Taught by Michael Wooi, from 29-Jul-2017 to 19-Aug-2017. Order ref F295625. Usage permitted only within these parameters otherwise contact info@thecasecentre.org 111-039-1 16