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Commerce · III.01 · MMXXVI · daylight

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WORKBOOK — THE CORPORATE EXECUTIVE

Chapter III.01 · What a Currency Is Made Of

For the person with a P&L, a treasury policy, a banking relationship and a board paper due. This workbook uses the language of the firm without apology, because the firm's own numbers already support most of what follows — they have simply never been arranged to show it.

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THE PREMISE, STATED COMMERCIALLY

Your firm holds three monetary positions and reports two of them.

1. A unit-of-account position. Every long contract you have signed — leases, offtakes, pension obligations, multi-year supply agreements, index-linked anything — is written in a unit whose real value drifts. That drift is a position. Nobody manages it, because it is not labelled as one.
2. A settlement position. Working capital, payment terms, the float. This one you do manage, and probably well.
3. A store-of-value position. Cash balances, reserves, the sinking fund against a known future capital call. This is where the most money is quietly lost, because an idle balance in a nominal currency is a short position on the real economy that nobody booked.

The chapter's argument, translated into your language: the three positions have different optimal instruments, and holding all three in ordinary cash means at least two of them are mispriced. The ninety days below fixes one of them at a scale that needs one signature.

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PART ONE — DISCOVERY

Days 1–30: find the positions you already hold

Exercise 1.1 — The unit-of-account sweep (one afternoon, with your CFO)

Pull every contract with a term longer than three years. For each, record:

• What unit is it written in?
• Is there an escalation clause, and what index does it reference?
• Who wins if that index runs hot? Who wins if it runs cold?

Output: a one-page table of your real unit-of-account exposures. Most firms running this exercise for the first time find three to five contracts where the firm is on the wrong side of an index it never chose, usually inherited from a counterparty's standard form. Repricing one of them is frequently worth more than the entire rest of this workbook, and it takes a fortnight.

Exercise 1.2 — The idle-balance question (two hours, with treasury)

Compute the firm's average operating cash balance across the last eight quarters, then the real return on it after inflation. Then ask the question the chapter asks: what is that balance a claim on?

If the honest answer is "nothing in particular", you are holding a store of value with no specified underlying, which is precisely the position the chapter argues against. That is not an argument for spending it. It is an argument for a named instrument with a dated maturity matched to the capital call it is actually against.

Exercise 1.3 — Where you already create money (90 minutes)

If you extend trade credit, you create a monetary instrument. Your receivables are somebody else's payables and they circulate — factored, discounted, assigned. Pull the balance and the average days outstanding, and write one sentence: we are running a payment system of this size and we have never called it that.

Exercise 1.4 — The regenerating stock inventory (one week)

List every stock on your balance sheet or off it whose condition can rise as well as fall: soil, woodland, water, plant condition, tooling, code quality, supplier capability, workforce skill, brand permission, licence to operate. For each, mark whether anyone measures it annually to a named method.

The ones that are measured are financeable this year. The ones that are not are a measurement project, and that project is cheap.

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PART TWO — THE ARITHMETIC

Days 31–60: run your own numbers

Exercise 2.1 — Your bank's balance sheet, and yours (two hours)

Understand what your lender is doing when it advances to you, because it changes how you negotiate.

  an SME advance                           GBP 750,000
  standardised risk weight, corporate SME          85 %
  total capital requirement                      10.5 %
  ----------------------------------------------------
  risk-weighted assets  750,000 x 0.85     GBP 637,500
  capital required      637,500 x 0.105    GBP  66,938
  money created per pound of capital           11.20 x

Compare with the residential mortgage in the chapter, where a 35 per cent risk weight gives 27.21×. Your risk weight is the price of your lending relationship, and it is negotiable in the ways that move it — security, seniority, covenant quality, a guarantee, an export credit wrapper. A change in risk weight moves your lender's capital cost directly and is frequently a cheaper concession for them than a change in margin.

Exercise 2.2 — Your indexation exposure, priced (90 minutes)

Take the longest contract from Exercise 1.1 and price the drift:

  unit drifting against you                         2 %/yr
  remaining term                                     30 yr
  -------------------------------------------------------
  (1.02)^30                                      1.8114
  real cost of the final payment vs the first    81.1 % more

Run it for your actual term and your actual index. A thirty-year exposure to a two per cent drift is an eighty-one per cent real change in the last payment. If that number is not in the contract file, it is not being managed.

Exercise 2.3 — The sinking fund you are already running (60 minutes)

If you hold reserves against a future capital call, compute what the carry costs you. Use the chapter's method with your own inflation assumption in place of demurrage — the arithmetic is identical and the sign is the same:

  fund required                            GBP 1,000,000
  years of accumulation                              20
  carry against the balance                    12.6825 %/yr   (illustrative)
  ------------------------------------------------------------
  annuity factor                                 7.3615
  annual contribution                      GBP   135,842 /yr
  total contributed                        GBP 2,716,840
  penalty factor                                  2.717 x

At ordinary inflation the factor is nearer 1.3 than 2.7, but it is never 1.0. Every sinking fund held in nominal cash is paying that factor and reporting it nowhere. That is the commercial case for the instrument in Part Four.

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PART THREE — DESIGN

Days 61–75: the board paper

The paper is four pages and no more.

Page one — the position. The three monetary positions the firm holds, with the number attached to each. No theory. The CFO reads page one and either turns the page or does not.

Page two — the proposal. One instrument, one stock, one term. The indexed regeneration note from the chapter, sized to the smallest useful issue.

Page three — the arithmetic.

  principal                                GBP 5,000,000
  real coupon on indexed principal                2.25 %
  expected index drift                            3.10 %
  nominal facility it replaces                    6.75 %
  -----------------------------------------------------
  all-in nominal  (1.0225)(1.031) - 1           5.4197 %
  spread vs the facility                        1.3303 points
  annual saving                            GBP    66,513 /yr
  over ten years, undiscounted             GBP   665,125
  breakeven index drift                         4.4010 %

Page four — the risks, each with its mitigation and its owner. Index risk sits with the firm above 4.40 per cent drift: state it, do not bury it. Covenant risk sits with operations. Measurement risk sits with the verifier you name.

What to expect in the room. Three objections arrive reliably.

"This is inflation risk we do not have today." You have it today and it is unhedged in the other direction: a nominal liability against a real asset. The note matches them. Concede the breakeven honestly and the objection converts.

"Why not just borrow normally?" Because the facility is 6.75 per cent and this is 5.42 per cent all-in, and because the covenant on stock condition is the thing that makes the asset financeable at all in the second decade.

"Who prices the index?" The best question in the room. Answer it with the custodian, the notice period and the published change history — never with software.

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PART FOUR — THE INSTRUMENT

Days 76–90: issue one internally

Do not go to a market first. The first issue is treasury to a business unit, documented in a fortnight, with no external party and no prospectus. It produces three things you cannot buy: a signed baseline, a measured stock, and a track record of a published index value that nobody adjusted.

The internal term sheet, in one page.

Balance-sheet treatment. Financial liability at amortised cost, indexation through finance costs as it accrues — the same treatment your auditors apply to any index-linked instrument. On the asset side, capitalise the regeneration expenditure and depreciate over the stock's regenerated life rather than its extracted life. An asset whose measured condition is improving should not run a schedule that assumes it is falling. This is a conversation about useful economic life, which your auditors have every year.

The number that decides it, and it belongs on page one:

   (1 + real coupon) x (1 + expected index drift) - 1   <   nominal cost of debt

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PART FIVE — THE SECOND YEAR

What the instrument makes possible once it exists

The first issue is small on purpose. What it buys is optionality, and the optionality is worth more than the 1.33 points of margin.

5.1 — The index becomes a procurement tool. Once you publish a unit and write one instrument in it, you can write supply contracts in it. A three-year supply agreement in index units removes the annual escalation negotiation entirely, which is typically two people's fortnight every year on both sides. Price that in your own overhead and it is frequently larger than the coupon saving.

5.2 — The covenant becomes an asset class. A stock with a signed baseline, a named measurement method and an annual published result is financeable by parties who cannot lend against a story. Pension funds, foundations and cooperative banks have long horizons and mandates that already mention exactly this, and their constraint has never been willingness. It has been the absence of a measured covenant to lend against. You now have one.

5.3 — The depreciation question reopens, profitably. Once the stock is measured annually, the argument for depreciating over its regenerated life stops being a theory and becomes an evidenced position you can take to your auditors. On a long-lived asset that is measurably improving, the change in useful economic life is often the largest single number in this entire workbook, and it arrives as a consequence of the measurement you built for the covenant.

5.4 — The treasury policy gets a third line. Most treasury policies specify counterparty limits and instrument types for the settlement position and the cash position. Add a line for the unit-of-account position: which index, who publishes it, what notice is required to change it, and what the firm does if the custodian changes the basket. Three sentences, written once, and it converts an unmanaged exposure into a policy.

Exercise 5.1 — The second counterparty (one week)

Name three external counterparties with a horizon longer than ten years and a reason to care about your specific stock. For each, write one line on what they would need to see. Then send one of them the audited first-year result, with no ask attached.

An audited result sent with no ask is the strongest opening available in this market, because everyone in it is used to receiving proposals and nobody is used to receiving evidence.

Exercise 5.2 — The reversal test (30 minutes)

Write, in one paragraph, what would have to be true for this instrument to be the wrong decision — and then check whether any of those things are measurable today. Two of them usually are. Put those two on the standing reporting pack, because a position reviewed monthly persists and a position reviewed by exception does not.

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THE NINETY DAYS ON A PAGE

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SELF-ASSESSMENT

For the executive, at day ninety

Eight or more: you have an instrument and a track record. Take it to a local authority pension fund, a cooperative bank or a foundation endowment — a counterparty with a long horizon and a reason to care about the stock.

Four to seven: the gap is almost always the baseline. An unsigned baseline is a future dispute, and every remaining item depends on it. Close that first.

Below four: the binding constraint is sponsorship rather than arithmetic. That is Chapter I.09, and it is a different problem with a different method.

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WHAT TO CARRY FORWARD

Your firm is already a monetary institution. It issues credit, it holds positions in units it did not choose, and it runs sinking funds against a carry it has never priced. Naming those three facts is the whole of this chapter at the level of the firm, and each of them has a number attached that your own systems can produce this month.