Chapter Seventeen

Art and Science of Risk Management

THE JURY IS OUT AS to whether risk management is an art, a science, or a process. We consider it to be a way of life, and a combination of an art and a science. In this chapter we introduce risk as a concept, defining and going through various ways in which it can impact the firm by focusing on the financial risk elements that come under the treasurer’s purview.

KINDS OF RISK

There are different elements of risk that you should know about. Here we discuss various categorisations of risk and some important considerations for managing risk.

The risk that we will be focusing on is the uncertainty associated with the financial performance of the company. Before we go ahead, there are some simple points to remember about financial risk.

• Risk means uncertainty, not necessarily losses. We usually associate risk with losses. Risk, however, is actually uncertainty. Making profits that you do not expect is also a risk. Stakeholders would be wary of profits or gains not directly linked with an increase in the business and any windfalls that would be hard to repeat by design.

• What we perceive as risk is not always the actual risk that we face. What is perceived risk and what is the risk in reality? Perceived risk is what is thought of as the risk. Actual risk causes us to be uncertain as to whether we will achieve something. Perceived risk is what we think can cause the uncertainty.

• Risk management is not necessarily about lowering risk. Risk management is the activity of identifying risk and reaching a state of risk that is required to achieve desired objectives. For example, if greater certainty of financials is the objective, lowering risk is the solution. If possibly higher revenues or lower expenses are the objective, this could be achieved by raising or changing the degree of risk, sometimes taking on more risk than the initial scenario in order to achieve such objectives. This still remains under the purview of “risk management,” but does not reduce risk and hence cannot be termed “risk reduction.” This is discussed in more detail in subsequent sections.

We now study the definitions of risk, trying to unravel what the risk categories are and how they can arise. Apart from the classical definitions, we look at other ways of categorising risk: by point of origination, by cause, and by immediate consequence.

CLASSICAL DEFINITIONS

The classical definitions or classifications of risk are:

• Business
• Financial
• Operations and technology
• Event

These have been summarised in Figure 17.1

FIGURE 17.1

Business Risk

Business risk is the uncertainty associated with the actual activity of doing business for a going concern. These risks are largely determined by the business managers in a firm and on-the-ground intelligence in global companies. Some elements of business risk are:

• Customer demand variability. The demand of customers—wholesale or retail—who buy the products or services of a firm could vary. Need, seasonality, technology, or trends could be some reasons for this variation.
• Competition. Always a strong driver, competition’s activities—whether they are the introduction of products, more aggressive marketing, or shifting prices—are always reasons for uncertainty of business performance.
• Pricing shifts. Changes in the price of raw materials, competition, customer demand, and other determinants, such as availability of capital or business reasons, could determine changes in pricing in a market. This is true in particular for price-elastic products, such as one’s dependence on commodities, and less true for price-inelastic products.
• Redundancy. Redundancy of product and sales channels could result in risk. For example, when cathode ray tube televisions were losing market share, more astute television manufacturers quickly replaced their manufacturing assembly lines to produce more new-technology televisions.
• Capital expenditure overruns. Projects usually have a long implementation period, and many internal and external events can delay their progress.
• Labor disputes. With increasingly proactive management of labor concerns and issues, labor disputes are becoming less of a concern in today’s management world. Yet, in some areas and regions, there still exists the likelihood of dispute, which in turn impacts business.
• People issues. Issues like employee turnover and poaching impact a business negatively.
• Merger and acquisition activity. Mergers, acquisitions, hive-offs, strategic sales, and other corporate finance decisions have a direct impact on the business and performance.

Financial Risk

Financial risk is possibly the toughest risk to define in a sentence. Broadly speaking, it is the uncertainty regarding the financial performance caused by creditworthiness, market movements, availability of money, accounting and tax situations, and balance sheet changes. Related yet different elements exist to create financial risk for a firm. These include credit risk, market risk, and accounting and tax risk.

Credit Risk

Credit risk is the uncertainty associated with the nonpayment of monies owed to a party by another party, for reasons of intent or financial or regulatory inability. There are various kinds of credit risk.

• Credit default risk. This is the most commonly used term for credit risk: It is the risk that anyone who owes the firm money does not pay it back. It usually is considered in regard to clients/customers, but recently companies are also closely looking at their exposure to credit default risk of banks. This risk could be a function of intention or ability. Management of this risk is detailed in further sections. Credit default risk is also referred to loosely as counterparty risk.

The following note highlights how a seemingly simple investment could also go wrong.

• Supplier credit risk. Usually a part of supply chain risk, supplier credit risk has increasingly entered the domain of credit risk management. While the supplier does not typically owe the firm money, a default or deterioration of credit at the supplier’s end will impair its ability to raise funding, which in turn could harm operations and disrupt the supply chain. Hence the move to monitor and address supply chain issues at the corporate end.
• Cross-border risk. This term refers primarily to two different risks:
  • Convertibility risk. Assume that a customer in Borderland owes the German subsidiary of your firm 6 million euro and has every intention of paying. The customer has all its earnings in local pesos and needs to convert its pesos to euros to make the payment. Now assume that the government of Borderland, due to a national debt crisis, passes a regulation to stop all conversion of pesos to foreign currency. This is an example of convertibility risk.
  • Transferability risk. Now let us assume that the customer actually does have an account in euros in Borderland and was willing to remit these (without having to convert pesos to euros to comply with the new regulation). Then the government of Borderland passes another regulation that prevents any remittance of money outward from Borderland. This is an example of transferability.
• Concentration risk. This is the risk that exposure to a single industry or business group or set of customers would produce significant changes in the firm’s financials. It is related to credit default risk in a contagious environment.
• Settlement risk. This is the risk that a firm’s counterparty does not deliver the settlement security, commodity, or cash equivalent after the firm has delivered its end of the agreement. One of the most prominent examples is the case of the Herstatt bank, whose license was withdrawn by German regulators at the end of banking hours owing to a shortage of flows and capital to cover short-term liabilities. Other banks that had already sent through their legs of foreign exchange transactions under the assumption that Herstatt would pay back the other leg were left with open receivable positions when the license was withdrawn. Hence, this risk is also sometimes referred to as Herstatt risk.
• Credit rating risk. This risk is the uncertainty (usually of an increase in cost of or difficulty in procuring funds from the debt market) following an unexpected downgrade in credit rating of the firm by a credit rating agency. This risk reflects a number of aspects, including business, operations, financial and event risks, but the event itself is a credit rating downgrade, and hence it is categorised under a credit risk.

Market Risk

Market risk (also referred to as price risk) largely refers to the uncertainty caused by the changes in market factors and environment. These could be simply moves of various market factors or the availability of capital. Market risks include factor risk and volatility risk.

Factor Risk

Factor risk is the direct consequence of moves in various market factors. It is usually more easily quantifiable if one knows the extent of one’s exposures.

• Foreign exchange (FX) risk. This is the risk that the firm’s value changes with changes in FX rates. This is one of the most commonly found exposures across firms and also one of the largest in terms of amount of risk for many multinational companies. Two key categories of FX risk are:
  • Transactional, which is caused by the need to physically convert amounts in one currency to another for a fund inflow or outflow or any activity requiring conversion to another currency.
  • Translational, which is caused by the need to translate an asset or a liability from a foreign currency to a local or reporting one, and has a direct accounting impact when consolidating or reporting balance sheet items across currencies.
• Interest rate (IR) risk. This is the uncertainty caused by shifts in interest rates. Given the linkages that most firms have with debt markets, either as surplus companies or borrowing ones, and with balance sheets and corresponding liquidity concerns, IR risk is manifested in many forms throughout a firm’s financial supply chain. Some forms of interest rate risk are:
  • Interest rate price risk. This is the most fundamental of IR risks—which represents the impact to the firm’s financials of any move in the interest rates of existing assets or liabilities—for example, a simple floating rate loan will yield a lesser cash outflow if rates move lower, or a larger outflow should the floating rate move up. Investments in bonds would get revalued when yields move, since the price of the bond is linked to the corresponding yield.
  • Yield curve risk. The shape of the yield curve (map of tenor-wise interest rates)—essentially the difference between short-term interest rates and long-term interest rates—changes, thereby opening up opportunities or shifting the valuation of a firm. The role of interest rates and yield curves in discounting also provides a variable element in the firm’s valuation.
  • Optionality risk. This is the risk of any liability being recalled by the investor or any asset being placed back by the lender. When mentioned specifically (as in the case of convertible bonds or callable or put table notes), these are explicit options and can be tracked actively. In some cases, especially in customer deposits for deposit-taking companies, the ability to take back money when required is an implicit option that lies with the depositor.
  • Repricing or rollover risk. For liabilities or investments, the change in applicable interest rates when the time comes to renew or roll over the liabilities or investments is an uncertainty.
• Commodity risk. Fluctuations in a firm’s value caused by changes in commodity prices are commodity risks. For companies such as oil refiners that buy raw commodities and sell processed ones, there exists a separate but related commodity exposure on both sides. Inventories are also revalued at current prices that make the call on inventory storage closely related to the management of the corresponding risk.
• Equity risk. Equity risk is the change in a firm’s value caused by a change in equity prices. For most firms, equity risk is restricted to equity market–related investments made by the firm, or the impact of capital instruments, such as convertible shares (whose exercise for convertibility is dependent on the underlying stock price).

Volatility Risk

Volatility risk is the change in the financials of the firm owing to the change in the volatility of a given market factor. Vega is the term used to denote the sensitivity of the value of the firm or the portfolio to changes in volatility.

Accounting and Tax Risk

Uncertainty caused by changes in accounting rules, tax laws, and statuses of group entities is reflected in this category of risk. Usually shifts in accounting and tax regulations are developments that happen over time, but sometimes sudden and dramatic changes have financially impacted global firms. A recent example is a retrospective tax law that impacted a telecommunication service provider in an Asian country—the matter is still in litigation at the time of going to press.

Liquidity and Working Capital

Liquidity risk is the impact on the firm’s financials by the inability to provide any entity within the group money required, when it is required, where it is required, and in the form that it is required. Any delay will cause a financial disruption and sometimes a very steep increase in the cost of funding if not planned well.

Why is liquidity risk different from market risk? They are related, in a way, with market liquidity being one of the primary sources of liquidity risk. Market liquidity risk is hence the risk that the firm will not be able to access money from the capital markets owing to a disruption or nonavailability of funds in the market. Funding liquidity risk arises from the firm’s own inability to meet liability payments when they fall due.

Ownership of assets that cannot be sold at a reasonable price when required is one of the key areas of concern and takeaways from the 2008 financial crisis. Instruments once thought to be highly rated and hence liquid changed characteristics (and ratings!) overnight, making a sale next to impossible and placing pressure on the firm’s liquidity. Figure 17.2 provides an overview of the different liquidity risks and their interlinkages.

FIGURE 17.2 Liquidity Risk

Operational and Technology Risk

Operational and technology risk (O&T risk or operations risk) is the uncertainty arising from the people, systems, and processes sectors of the company’s Treasury and financial operations.

Operational risk is managed differently from other types of risk, because it is not a direct variable or external aspect that can be tracked. In effect, organisations need to accept that their people, processes, and systems are not perfect and that there are chances that losses will arise from errors and nonrobust operations, technology, and controls. Determining measures and governance for operational risk is an evolving science. Some of the more common areas of operational risk are:

• Manual errors
• Systems failure
• Government intervention or regulation
• Supply chain disruption
• Third-party failure
• Fraud
• Regulatory and compliance issues

We cover the area of operations and control processes in more detail in the Toolkit in Part Five.

Event Risk

Event risk comprises these possible areas:

• Reputation
• Political
• Acts of God
• Terrorism/sabotage
• Strikes
• Liability/litigation

These risks are usually outside of the purview of a firm’s Treasury. Some are insurable. The chief executive officer along with the business heads and the chief financial officer (CFO) would weigh in on the probability, costs, and hence management of these risks.

Other Classifications of Risk

Risk elements can be classified in other ways, as shown in Table 17.1. The importance of these classifications is that they help Treasurers to look for points in the system that could be potential areas or sources of risk, which would help in the first stage of the risk management process.

TABLE 17.1 Other Classifications of Risk

Risk management is a process and a philosophy as much as it is a practice. If enough thought and effort has been put in to get the process right, it reduces the chances that things will go wrong and increases the chances that the firm’s financial performance is in line with the expected objectives, the variables that are more dependent on business performance and less on the markets.

WHY MANAGE FINANCIAL RISK?

Some of the reasons for managing financial risk are fairly evident, yet from the perspective of the CFO and Treasurer, financial risk management provides three key elements. We go back to the key performance indicators of the Treasurer mentioned in Chapter 1 and tie them in with the objectives of risk management. This is depicted in Figure 17.3.

FIGURE 17.3 Key Performance Indicators of the Treasurer in the Context of Risk Management

Increased Stability of Cash Flows and Balance Sheet

Smoother earnings and more accurate forecasts ensure that investors and lenders are more comfortable with the company’s financial performance. Widely varying profits, even if they are increasing, and a very high dependence on FX rates rather than higher actual sales, for example, could result in a critical assessment of the company’s financial condition. Similarly, poor management of liquidity could result in a spike in interest expense to raise money in crisis situations, which impacts the company’s profitability rather severely. Similarly, stability of assets and liabilities, especially across debt and capital investments, is a good indicator of a firm’s control over its financial management.

Improving predictability of earnings by determining the financial value of the expected earnings in advance also shows a high degree of management control over the firm’s performance. This fosters a stable planning environment for business managers, who can focus on sales and development of their client segments without having to be unduly worried about the currency, liquidity, market, or other aspects.

Lower the Cost of Capital

By managing interest rate risk and neutralising the impact of interest rates or helping to lock in long-term rates through prudent use of interest risk management devices, the Treasurer contributes directly to stable and improved capital costs.

By reducing the likelihood and potential costs of distress, a good risk management process can move the firm towards becoming neutral to performances of its key market and credit environments and hence towards a better rating. A better rating would imply increased ability to leverage and cheaper sources of funding, leading to an overall lowering of the cost of capital.

Prevent a Liquidity Problem

Managing liquidity risk is a critical part of the risk management activity. Through processes and initiatives discussed earlier we observed how the entire process of liquidity management, tracking, and preventing liquidity shortfalls through effective management of liquidity risk prevents a liquidity event from taking place.

Sometimes global events take a toll on certain markets in terms of liquidity. These events can sometimes be triggered overnight because of some financial or other event, but in most cases can be expected when there is a deterioration of market and liquidity conditions. The impact of these events on the firm’s day-to-day functioning should be minimised through prudent risk management. The ability to live through any stress situations with the firm’s financials intact distinguishes a great Treasurer from a good one. Some recent crises are listed in Table 17.2.

TABLE 17.2 Some Large Market Crises over the Years

Enhance Competitive Advantage

Providing the sales team with more flexibility on pricing and hence better customer terms and conditions could help business units beat competition on pricing while retaining operational efficiency for the firm and keeping the sales margins high. Increased business is always good news.

STYLES OF RISK MANAGEMENT

Some of the various styles of risk management are indicated in Figure 17.4.

FIGURE 17.4 Styles of Risk Management

Various cases exist of each of these styles, and many treasuries have one predominant style. The risk management styles that are most effective combine various styles based on requirements. It is most important to have a defined plan based on a well-defined policy and to be consistent with that policy. A strong and flexible policy will allow for some degree of variance of styles, but most parameters should be kept within a range of operation and style.

It is important to align the style of Treasury functioning with the working style of the organisation and with management perspective. Sometimes the improvement in Treasury processes could result in improvements in the organisation process and planning itself, as we saw in the recent situation of an American firm.

Finally, many clients say: “We are very conservative. We do not hedge.” As expressed in the note, this may be an example of an extremely aggressive strategy, leaving the firm’s fortunes to the mercy of the market, as the following note describes.

FACTORS IMPACTING RISK

Many elements impact the formation, growth, reduction, and continuation of risk elements for a transnational firm. Some of these occur in the course of doing business and hence cannot be eliminated. The risk manager must simply assume these risks and manage them, and notify management on the extent of the unmanageable or pending risks. Management would then be able to review the continuation of the business strategy that brings these factors into the firm’s risk.

Location

Locational aspects of risk are provided next. Table 17.3 illustrates these risks.

TABLE 17.3 Locational Aspects of Risk

Location of the Company and Subsidiaries

The location of the parent determines the currency of the balance sheet, funding requirements, tax aspects, accounting treatment, regulations, use of cash, investment, and other critical aspects. The location of subsidiaries determines funding cost, liquidity, reparability, and cross-border and FX risk.

Location of Customers or Clients

Where the clients are located usually determines the currency of sales. Market practice on receivables and credit period impacts the balance sheet and hence funding requirements.

Location of Suppliers

Where the suppliers are located, similarly, could determine the currency of purchases as well as availability of supply chain financing and credit facilities for suppliers. Payment practices also determine the length of credit period extended by suppliers and hence funding requirements.

Location of Invoicing

As mentioned earlier, the location of invoicing determines tax and exchange matters. Companies are increasingly selecting invoicing location to improve the risk and cost profile of invoicing.

Location of Inventory and Manufacturing

Inventory across currencies results in translation issues as well as funding-cost and liquidity-related matters.

Location of Treasury

Centralised Treasuries or regional Treasury centres have a more holistic and hence better overall perspective of the firm’s risk than the individual subsidiaries or individual entities and contribute towards concentrating the risk and balance sheet elements in fewer locations.

State of Economies and Markets

The state of the economies and markets impacts the predictability and stability of market factors and liquidity and also cost of raising or returns on invested capital. These are extraneous factors, and the CFO or Treasurer can do little to change these environments.

Processes

Internal processes and their location is a strong determinant of risk and its measure. Operational risk and control is a core element of the treasurer’s responsibility, and the robustness of internal processes becomes a critical part of the firm’s success.

Bargaining Power

The ability to bargain with customers and suppliers and to negotiate terms favorable to the firm is an important source or mitigate of risk.

Nature of Industry and Competition

Industry practices and competitive action impact the nature of risk that the company faces. Distribution and concentration of suppliers and clients’ need to match competitor actions (e.g., entering markets with a high degree of credit risk or invoicing in a foreign currency), industry standard terms and conditions, leverage, and other factors influence the degree of risk of a firm.

What You Start Off With—Zero Base

If the firm has an existing hedging mechanism or long-term contracts that cannot be unwound or changed, they will have to be considered for risk purposes and included in the items to be managed.

WHAT DOES RISK MANAGEMENT DO?

Risk management attempts to move a firm’s risk profile from an existing profile towards an intended or targeted one. In this context, it is a good idea to introduce the probability distribution as an intelligent method to describe risk in its actual and intended form.

Probability Distribution

A probability distribution curve measures the probability of where market prices can be in the future. The distribution can assume any shape, as long as the sum of all possible outcomes (area inside the curve) is 1. This distribution is similar to a set of balls falling into a bucket or a flow of grains of sand onto the floor (see Figure 17.5).

FIGURE 17.5 Probability Distribution

The balls finally take on a normal distribution, with the highest point in the same line as the halfway point on the line. This is popularly called the Bell curve. Normal distributions can be applied to many instances in our daily lives (see Figure 17.6). For example, if the average (mean) height of a class is, say, five foot six inches, the tallest person will be the most distant in the distribution on the right side and the shortest person will be the most distant on the left.

FIGURE 17.6 Mean

Figure 17.6 is explained in the following note.

So it is with markets: Statistically, we assume that the chance of the market factor rate (say EUR USD currency spot rate or USD five-year Treasury yields, or West Texas Intermediate (WTI) oil futures prices) ending on either side of the halfway point, or mean, is equal. That is, there is an equal likelihood of the market factor ending on either side of the mean rate. Let us assume that this mean rate is the forward price of today. The farther away from the mean, the less likely it is that the factor will end up at that rate. Hence, rate A2 is less likely to occur than rate A1. Or the market factor rate is less likely to end up at A2 than it is at A1.

How less likely? Figure 17.7 leads us in that direction.

FIGURE 17.7 Probability of Occurrence and Market Factor Rate

The standard deviation (represented by the Greek letter sigma, σ), represents how much variation is expected from the mean value. A measure of 1σ represents a dispersion of 1 away from the mean. The reader is referred to textbooks on statistics for a detailed reading of normal distributions.

The area inside the curve to the left of a particular point on the x-axis represents the total (cumulative) probability that the market factor will end below that rate. For example, the probability that the rate ends below a point +2σ away from the mean is around 97.7%.

Figure 17.8 shows the mean of probability of occurrence with a market factor rate.

FIGURE 17.8 Mean of Probability of Occurrence and Market Factor Rate

Which do you think is the most volatile currency in Figure 17.9, A, B, or C?

FIGURE 17.9 Which Is the Most Volatile Currency?

The answer is C. Surprised?

A is the least volatile, because the standard deviation is fairly low. The dispersion away from the mean is least. For currency pair C, the dispersion away from the mean is the most, and hence the probability that the rate would end far away from the mean is higher, as the probability is lower that the rate will end around the mean.

OBJECTIVE OF RISK MANAGEMENT

Now that we have learned the basics of a probability distribution, let us apply that to a firm’s risk management. Recall that earlier we defined risk as the uncertainty that would impact the financials of a firm. Let us now draw up a distribution of the firm’s expected value around the mean, with probability of achieving a particular value (Figure 17.10).

FIGURE 17.10 Expected Value of the Firm

The risk to the firm is that the firm value would end up away from what is expected. An adverse performance (i.e., towards the left of the mean) would not go down well with stakeholders. Nor would an unexpectedly better performance because of market moves (i.e., towards the right of the mean), since similar market conditions would not be anticipated in following years, making an improvement over the current year’s performance even more challenging.

Many CFOs prefer to keep the firm value around the expected or mean value. In such cases the firm’s risk management has a risk reduction focus.

Risk reduction would hence mean being closer to the mean and less dispersion. The CFO or Treasurer seeking risk reduction would aim to achieve the curve Y as compared to curve X (see Figure 17.11). In this case, the likelihood of ending up closer to the mean is much higher, and that would be the core objective of a risk management policy and mechanism oriented towards risk reduction.

FIGURE 17.11 Risk Reduction and Risk Management

More aggressive CFOs would look towards maximising firm value. Treasurers would devise strategies to get a better rate than what the market offers. However, these kind of strategies typically entail a higher likelihood of a negative scenario. Therefore, while the chances of a higher targeted firm value than the mean increase, so do the possibilities of a worse value than the mean. The distribution of a typical targeted risk strategy is depicted in Figure 17.12.

FIGURE 17.12 Sample Targeted Risk Strategy

Two terms are often used interchangeably, and this practice might not always be correct. We clarify in the following note.

SUMMARY

Risk can be viewed in different ways and can mean different things to different people and organisations. Also, many companies treat risk in different ways. This chapter viewed risk from different perspectives but finally quantified financial risk in regard to the impact that it has on the organisation. The rest of this part of the book is devoted to the management of various kinds of financial risk, using a best practices approach.