Chapter Nineteen

Risk Management in Practice: Ensuring the Right IMAGE©

THERE ARE MANY APPROACHES TO risk management in practice, and each firm needs to institutionalise the practice that works for its Treasury design, culture, objectives, and management.

IMAGE© METHODOLOGY1

The IMAGE© methodology consists of five easy-to-implement and manage steps:

Figure 19.1 outlines the IMAGE© methodology.

FIGURE 19.1 IMAGE© Framework for Risk Management

RISK IDENTIFICATION

The objective of the risk identification stage is to identify the financial risks to which the firm is exposed. These arise because of the nature of business activity and geographical presence across markets.

How does a firm know which risk it is sitting on? Anything that moves or has variability is a risk—these include market exposures, supply chain elements, balance sheet items like accounts receivable (ARs) and inventory across currencies, dependence on liquidity, exchange control, process implementation, and so on.

Risk identification uses some simple methods to identify, bottom-up, the various risk elements, which can then be quantified so that management can decide to focus efforts on managing certain risks.

Sources of risk are easily identifiable through examining a line-by-line breakup of all elements of the balance sheet and cash flows. Any element that is impacted by need must be taken into account:

• Foreign exchange moves
• Interest rate moves
• Commodity price changes
• Liquidity of market and availability of capital
• Creditors
• Human intervention (processing)
• System impact
• Geographic presence
• Change in regulations
• Accounting and tax changes

One of the most important aspects of risk identification is risk awareness, and all functions need to be involved in identifying potential risks in their areas. Treasury itself will manage these financial risks, but the involvement of the other functions in the identification process is critical, since the touch points to the areas of risks could arise through their interactions and domains as well. This is especially true of remote locations and interfaces, whose inputs would be the primary ones used by centralised treasury for decision making and corresponding risk management.

Table 19.1 provides an overview of the primary drivers and sources of risk. A zero-based approach to each item in the financials provides the answers to the elements of risk.

TABLE 19.1 Various Elements of Firm Financials and Possible Areas of Risk

Based on the list of identified risks, each risk is quantified using the measurement tools in the next section titled “Risk Measurement.” This measurement will form the basis on which the risks that need to be managed will be selected.

RISK MEASUREMENT

In this stage, financial risks for each of the risks identified in the earlier stage are measured or quantified as is their sensitivity to operations and financials of the firm.

The discussion of which methods or practice to use for measurement of risk and assessing the degree of risk is an involved one, and needs to include the Treasurer and the Treasury team along with the chief financial officer (CFO). This assessment should be incorporated into the policy and approved by the board.

Many measures can be considered. For most corporates, simple measures that are also flexible and easy to implement, when well used, yield better results than abstruse and complicated analyses using complex technical terminology and fancy graphs—these might look good on a presentation but could pose serious implementation bottlenecks on the ground.

Two aspects to bear in mind prior to starting the measurement process are highlighted in the note below.

Figure 19.2 zooms in on the risk measurement process.

FIGURE 19.2 Risk Measurement in Context of the Entire Risk Management Process

The risk measurement process consists of two different methods:

Some methods used to measure or dimension the risk are discussed next.

Discrete Methods

Simple discrete methods of measuring the risk use calculable factors that depict the current status of risk at any point of time.

Factor Sensitivity Analysis

Sensitivity analysis, which is especially useful to measure items related to market risk, shows the firm how a certain change to a market factor impacts the financials (firm value).

For example, the factor sensitivity (FS) of the EUR USD on a firm’s value could be USD 12.3 million for every 0.01 change to the EUR USD exchange rate.

For a leveraged company, the FS of USD interest rates could be USD 6 million for every basis point (0.01%) shift in the USD yield curve.

Factor sensitivities, when superimposed on historic moves and future scenarios, provide a strong input into deciding which risks to focus on. Materiality of the risk is a call taken as part of the decision on which risks to hedge.

The three main factor sensitivities to monitor as part of the risk management process are:

Scenario Analysis

Scenario analyses project financial performance over a period of time, across different scenarios. These analyses can be either descriptive scenarios, implying specific moves on the market factors, or numeric scenarios. Figures 19.3, 19.4, 19.5, and 19.6 depict sample scenario analyses.

FIGURE 19.3 Descriptive Scenario on Generic Measure (EBITDA)

FIGURE 19.4 Descriptive Scenario on Specific Measure (FCY Loan Portfolio)

FIGURE 19.5 Numeric Scenario with Specific Measure (Change in Loan Outflow)

FIGURE 19.6 Post-Hedging Numeric Scenario with Conditional Payoffs After Each Year of Hedging

Figure 19.3 shows a sample set of descriptive scenarios—it is important to remember that descriptive scenarios do have actual numeric assumptions on each market factor. The main advantage of descriptive scenarios is that it could include assumptions on more than two factors and hence can be represented in one table. Figure 19.4 provides a descriptive scenario on a specific risk (loan outflows) with more than two factors being impacted by the scenarios—for simplicity, we have depicted the top two.

Figure 19.4 shows a sample set of numeric scenarios for a generic measure. Numeric scenarios are usually across two factors and can be adjusted to include perhaps a third factor. Any more factors could impact readability. A sample numeric scenario for a specific risk is given in Figure 19.5.

The scenarios should factor in these issues:

• Historic levels (covering ranges over the past 10 years at least)
• Current expectations of levels received from banks/research desks (since these will be in a range, the elements in the range can be covered)
• Any regulator’s comments
• Geopolitical situation and event probabilities
• Cyclicality
• Technical levels or big-figure levels close to current levels
• Linkages with global markets (e.g., currency depreciation in case of emerging markets pullout)

Stress Scenarios

Stress scenarios are specific scenarios that place a stress on the market in terms of:

• Extreme and sudden movement of market factors
• Cross-border events
• Liquidity problems
• Credit events and defaults
• Regulatory changes
• Supply chain disruption
• Peer or industry event
• Company-related event (such as reputational issues, operational loss, etc.)
• Regulatory or government action on the group

The aspect most critical to the functioning of a company in these situations is liquidity—the ability to provide cash or funding to group entities that need them. Mark-to-market losses, while important, are themselves not directly the most critical, for in quite a few cases, these losses can be managed or limited by restructuring the original transaction with restricted incremental losses. Liquidity, however, is usually an immediate requirement, and the inability of the firm to tide itself over an absence of liquidity can be enterprise threatening. Mark-to-market losses can result in a shortfall of liquidity, as can be a credit event or a regulatory change.

Each stress level must have certain assumptions associated with it that must be ratified by the treasury management committee and approved by the board as part of the annual review.

Results are usually used to determine the focus of contingency plans, especially on liquidity. If required, the portfolio is amended or hedges are put out to reduce the stress in some cases. Trigger levels can be used to set early-warning levels that could result in action on the portfolio before such scenarios actually occur. Experiences from earlier stress events are also useful to bear in mind while evaluating scenarios and impacts of events on the financials of the firm.

Discrete Measures of Liquidity Risk

Discrete measures of liquidity risk are simple snapshots that can provide a good overview of the liquidity at any point and also targeted levels that can trigger measures in case they are exceeded.

Liquidity Gap

Liquidity gap can be defined as the excess value of the firm’s liquid assets over its volatile liabilities. A negative liquidity gap implies that a company could be underfunded in some situations and must try to build longer-term funding sources. A disadvantage of this measure is that it does not relate to the funding cost of the group.

Asset Liquidity Measures

Alexandra Hachmeister has defined some asset liquidity measures: bid-offer spread, market depth, immediacy, and resilience.

The bid-offer spread is a good measure of liquidity of an asset being held by the firm. The smaller the spread, the more liquid the asset is.

Market depth is the amount of an asset that can be bought and sold at various bid-ask spreads.

Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.

Resilience can be defined as the speed with which prices return to former levels after a large transaction.

Probability and Statistical Methods

Various probability and statistical analyses exist, implemented through formulas, models, distribution testing, and other methods. Of late, VaR has been mentioned a lot in the news.

The success of some of these methods has been debated in the corporate setting, owing to the related complexity, margin for error, and ability to work under all conditions and market environments. In my view, most corporates can measure risk prudently using simple tools, such as scenario analysis and factor sensitivities, before and after hedging.

Value at Risk

Many companies have started using VaR as a risk measure. If the complexities of the operations and assumed risks are commensurate with the use of this interesting method as a tool (see the box titled “The Art of VaR”), it can indeed be an ally.

VaR is a measure of how much the value of a firm, portfolio, or financial position can change because of movements in market factors, such as foreign exchange rates, interest rates, commodity prices, and stock prices. Hence, the Treasury or portfolio manager can state with a certain degree of confidence, in most situations, the maximum loss that the firm or portfolio can suffer over a particular period of time.

Corporates use VaR as a general measure of risk, as a limit for exposures to market factors, and to evaluate cash flows and liquidity situations (CFaR and LaR respectively, discussed in more detail later in the chapter).

There are three commonly used methods for calculating VaR: historic rate, variance/covariance, and Monte Carlo.

Back-testing the VaR result with historical performance is used in accompaniment to current VaR readings in many cases, to show how the same methodology would have fared in different times. VaR can also be used across scenario analyses and stress testing described earlier.

Many books and articles describe VaR and how to build models around it. Here we mention just the important and salient aspects here, including volatility and correlation.

Volatility

With the advent of option pricing, volatility has become one of the most studied, debated, used, and misused tools in financial management. It is essentially a mathematical measure (in percentage) of the variability of a particular market factor or instrument. Volatility is a nondirectional measure (always positive), since it measures both increases and decreases in the value of the factor or instrument. The higher the volatility, the higher the financial risk.

Volatility can be obtained using standard deviation, a popular statistical measure, usually expressed in annualised terms, such as interest rates. Standard deviation can be easily obtained from historical data using the simple formula

where:

n = number of observations

xi = lognormal return of observation i over observation i − 1

x = average lognormal return of the data

Some measures of volatility are:

• Historical volatility. Measured by historical trends and data
• Implied volatility. Quoted and traded by traders in professional markets; it is commonly used in pricing options
• Exponential weighted moving average. More complex statistical methods that remove certain problems that creep into simpler methods

One of the commonly discussed issues with probability distributions is the fat tail—the probability of extreme values in the price being greater than estimated by a normal distribution. And when the market liquidity dries up, the fat tail tends to become fatter.

Correlation

Correlation is the extent to which the prices of two factors or instruments are linked to each other: If the correlation is close to 100% or 1, the two prices move very closely or largely in tandem. If the correlation is close to −1, the two move oppositely. If the correlation is close to zero, there has been no observable pattern or relationship between the two.

Correlation is a critical aspect when looking at diversification or optimising a portfolio. For example, if a company has payables in two highly correlated factors (e.g., EUR USD and USD CHF, as shown in Figure 19.7), the risk is more concentrated than if it had payables in two currencies that were most highly correlated (viz., the two currencies have moved similarly at the same points of time over a certain time horizon). The risk of a portfolio that has two highly correlated risky assets is much greater than a portfolio of two uncorrelated risk assets.

FIGURE 19.7 Correlation Between EUR and CHF

Source: Thomson Reuters Eikon

When assessing a portfolio for VaR, the correlation aspect is generally considered since the prices of different factors move differently, and the movement of a portfolio as a whole must be factored in.

Liquidity-Adjusted VaR

A derivative of VaR is liquidity-adjusted VAR—a measure that incorporates liquidity risk into VaR. The premise here is that in some situations, the holding period for an asset could be higher than normal, and there is a corresponding cost of holding that asset prior to unwinding the position.

Cash Flow at Risk

CFaR borrows from the concept of firm or portfolio value and focuses it specifically on cash flows. This is more applicable to firms whose primary objective is to monitor their cash flows and their predictability since it estimates with a certain degree of confidence how the cash flows will change in most situations.

Liquidity at Risk (LaR)

LaR is a measure of liquidity—what the firm’s liquidity position across most situations would be. LaR is more relevant to banks and FIs, but it can be used by companies if it adds value to their measures.

We now present a case in a parallel universe—almost literally. We go through a decision-making situation at a space agency, and will see how it is related to our world of corporate financial risk.

CASE STUDY: WHICH RISK TO HEDGE? A NASA EXPERIENCE

With constraints (such as cost or resources) to being able to manage only certain kinds of risk, it is useful to have a risk comparison structure in place to be able to make the right choice as to which risk should be the first to be hedged. We explore a parallel case here with the National Aeronautics and Space Administration (NASA) having to choose one, and their Risk Assessment process. Parallels can be drawn very easily with what the Treasurer and CFO can do in their own context.

Background: NASA’s Risk Assessment Process

NASA defines risk as the uncertainty of achieving a desired outcome and has in place a detailed but simple risk architecture that covers the two key elements of risk assessment:

• Likelihood of the Risk: What is the probability that the risk will occur, or that the event that triggers the risk will happen? Various mathematical, analytical and subjective models exist for the calculation of such numbers; the final output could be a combination result of all of these.
• Consequence of the Risk: What happens once the risk is triggered? Are there consequences that could be human, financial, compliance, competitive, industrial or even political?

Risks are classified by the types and consequence of their occurrence, such as:

• Schedule. The risk, when it occurs, causes delays in implementation and execution. In many of these cases, there is a direct or indirect impact on cost, but when working with tight schedules, the inability to meet deadlines is a critical requirement.
• Cost. Most risks usually end up with a cost element. This category covers the risk elements that have a direct impact on cost, should they occur.
• Technical/Performance. Any risk that directly impacts the performance of a spacecraft or a programme because of technical glitches or poor performance is categorised in this heading.
• Technical/Safety. The most important by far of all of these, this covers the loss of human life as a result of technical malfunction. There is zero tolerance for this kind of risk in any programme under any circumstance.

The risk assessment process logically builds on the above and answers the following questions:

• What can go wrong that could lead to an undesired outcome?
• How likely is this to happen?
• If it happens, what consequences are expected?

Figure 19.8 summarises the background of NASA’s risk assessment process.

FIGURE 19.8 Background of NASA’s Risk Assessment Process

Situation: Have to Pick One Risk to Mitigate—Which One to Pick?

The International Space Station (ISS) is a habitable artificial satellite in low Earth orbit (depicted in Figure 19.9). The ISS serves as a microgravity and space environment research laboratory in which crew members conduct experiments in biology, human biology, physics, astronomy, meteorology and other fields.

FIGURE 19.9 International Space Station

Because of the limited launch capabilities to bring items up to the Space Station, a risk question arose about reduce the most risk by selecting the launch vehicle manifest on two critical items to be flown. Knowing that only one risk reduction component could be flown on the next mission to the Station, either a portal window cover for the external viewing window that the crew uses for earth observation or a spare CO2 scrubber for the environmental control system internal to the Space Station (see Figure 19.10).

FIGURE 19.10 Which One to Pick?

Both were items that would reduce certain elements of risk, and the decision had to be taken as to which one would be flown up (limitations on spare only allowed one of these components to be flown):

• Service Module (SM) Window Cover. The SM window cover would reduce the damage to the SM window should it be hit by orbital debris (either space junk or natural micrometeorite debris in space).
• Spare Vozdukh core. Vozdukh is a permanent recycling system in the ISS that removes carbon dioxide from the air based on the use of regenerable absorbers of carbon dioxide gas.

Risk Assessment Process Using the Probabilistic Risk Assessment Model

This is where the risk assessment process of NASA, using the probabilistic risk assessment (PRA) model, came into play. The architecture for the PRA model is given in Figure 19.11.

FIGURE 19.11 PRA Architecture (Futron Corporation)

Source: Futron Corporation

Figure 19.12 articulates the process for the PRA model. As can be seen, the process follows a logical sequence of events that involve a data-gathering stage, an analysis stage, and review and decision-making stage.

FIGURE 19.12 PRA Process

The process also assumes a hard and unambiguous definition of roles and responsibilities for each activity and decision to be made. This is summarised in Figure 19.13.

FIGURE 19.13 Clear Roles and Responsibilities

Application and Decision Making

In this case, the two alternatives were compared from a risk perspective (Figure 19.14) to determine the relative reduction in the probability of defined end states (i.e., loss of crew, loss of Space Station, crew evacuation, loss of experiments/science). This analysis compared the risk reduction of supplying a SM window cover versus the Vozdukh core relative to a baseline (where neither item is flown up to the Space Station).

FIGURE 19.14 Results of Comparative Analysis

Contributed by Jeevan Perera, PhD, JD, Johnson Space Center, NASA

The evaluation and assessment of the end states was done based on different scenarios, including stress scenarios. The risk analysis demonstrated that supply the Space Station with the service module window cover reduced more risk than the Vozdukh core. The final decision was made to send through the SM window cover based on the analysis.

Learnings

In real-life treasury, we face many situations where there are constraints. These could be budgetary constraints on hedging cost or resource constraints on people managing these risks (sometimes it is more difficult to start a hedging process and to manage it if there is a shortage of resources).

NASA’s approach can help us review our own decision making process for our financials, where we have limitations and can pick only one hedge to focus on. On a broader level, some of the best practices that can be derived from the case in a corporate treasury are listed next.

• Scenario analysis, historic levels, and financial impact of various outcomes are indispensable elements of the risk assessment process.
• Measurement of risk and its impact is key.
• Measurement through scenario analysis and various outcomes makes it simpler for management to make decisions on which risks to hedge and to frame the general risk governance aspect of risk management.

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RISK ACCOUNTING AND REPORTING

The risk accounting and reporting stage accounts for and reports the various risks to relevant levels of management. Accounting and reporting risk have to be consistent in regard to accounting practices, rates for valuations, tallying across subsidiaries, and consolidation in parent books, regular reconciliation, independence, and regularity and format of reporting.

Clear responsibility between Treasury and financial control on ownership of data, systems, and activities is essential, as is teamwork between the two functions.

Teamwork brings us to another much-debated point: the accuracy of forecasts coming in to Treasury, based on which Treasury does its risk management activity. Inaccurate forecasts often result in adverse hedges being booked, either for short/excess amounts or for wrong time frames. In volatile markets, these could result in sufficiently negative numbers.

Since forecasts are usually the basis for many hedges, the entire exercise has to be taken with utmost seriousness and gravity by business and cost centres. Many successful firms implement processes to track forecast error, with accurate forecasting being one of the areas of evaluation for subsidiaries and country operations. Treasury can work with the businesses to provide data and trend analysis to help increase forecast accuracy.

The problem becomes more acute when accounting norms prevent losses owing to forecasting errors from being deferred and increase reporting requirements. In some cases, repeated forecasting errors could endanger long-term hedge effectiveness and hence impair the firm’s ability to receive hedge accounting treatment.

Reporting is also an independent activity, and firms are moving towards automating it to reduce manual intervention and thus become more timely and accurate. Overreporting is also a danger, and hence the treasury policy must stipulate the formats, recipients, and frequency of regular reporting.

Exception reporting must have its own separate process and escalation mechanism.

RISK GOVERNANCE

After having put in place the basic infrastructure of the risk management process, we come to the fourth stage: the “doing” of the risk management activity.

Risk governance involves stipulating the objectives, scope, risk factors, time horizons, tenors, amounts, tools, methods, timing, and personnel to execute the risk management activity. These elements are further described here.

Objectives: Why Hedge?

Different firms have different objectives for risk management—more conservative ones focus on reducing the variability on future cash flows and balance sheet and increasing the visibility of the firm’s financials. Some seek to optimise the above objectives with an added flexibility of obtaining market rates and timing entry of hedges. More aggressive ones seek to create treasury as a profit centre and use the firm’s balance sheet to assume specific financial risks for targeted returns.

In some situations, the firm could believe that the element of the risk is not material and that visibility and certainty of financials is at an appropriately desired level. In this case, the risk management activity becomes passive.

Scope and Risk Factors: What to Hedge?

The risks that will be managed by factor have to be stipulated. Material risks determined at the measurement stage are usually included. The basis for deciding the risks to be hedged is the impact of the risk on the organisation and the approximate factor sensitivities must be documented.

Time Horizons and Tenors: How Long to Hedge For?

The maximum allowable tenor for the hedges is determined. It usually is in sync with the time horizon as determined during the measurement stage.

Each risk class, or even each market factor, could have a different time frame, though in the absence of good systems and reporting, using different timeframes for different factors could complicate the entire process of tracking, evaluation, and reporting.

Amounts: How Much to Hedge?

The extent of the risk to be managed or hedged needs to be determined. Hedging ratios (using the M-D-U proportion) can be maintained for each of the elements. The M-D-U proportion provides for a mandatory (M%) percentage of the stated exposure to be always hedged, a discretionary portion (D%) to be hedged based on the judgement of the hedger, and an unhedged portion (U%) that will always remain unhedged. Minimum and maximum ratios of the extent of hedging over the time horizon for hedging will be provided.

This can create a layered hedging strategy across tenors. Figure 19.15 depicts a typical layered hedging strategy over time, which allows for some discretionary hedging.

FIGURE 19.15 Layered Hedging Strategy

Tools and Methods: How to Hedge?

The tools and products that can be used are decided at this point (see the development of a hedging strategy in Chapter 22). These have to be consistent with the tenors and hedging proportions decided above.

Tools and products can be categorised into the market instruments, products related to financing and balance sheets, avoidance, and diversification or portfolio optimisation.

Market Instruments

Market instruments are available as over-the-counter or exchange-traded contracts. They require some form of credit risk limits from and with the other counterparty, collateralisation, or up-front payment of premia. Market instruments could be price insurance, price fixing, price variability, or combinations thereof.

Price insurance contracts provide protection in a worst case, while providing some extent of upside in case the interest rates move in favor of the buyer. They are like buying insurance on specific elements. There could be a premium paid up front for this insurance. Vanilla options (calls, puts, caps, floors, etc.) are examples of price insurance contracts. Figure 19.16 presents an example of a price insurance contract (USD interest rate cap); its payoff profile is shown in Figure 19.17.

FIGURE 19.16 Example of Price Insurance Contract (USD Interest Rate Option [LIBOR Cap])

FIGURE 19.17 Payoff Profile of USD LIBOR Cap

Price-fixing contracts ascertain the price for the firm on any underlying market factor, with an opportunity loss being created should the markets move in their favor. Examples are forward contracts, rate locks, and interest rate swaps where the firm receives a fixed rate and pays a floating rate. An example of a price-fixing contract (FX forward) is illustrated in Figure 19.18, and its pay-off profile is shown in Figure 19.19.

FIGURE 19.18 Example of Price-Fixing Contract (FX Forward)

FIGURE 19.19 Payoff of Price-Fixing Contract versus Unhedged Scenario

We can illustrate the opportunity loss described above. If the corporate had remained unhedged, a move lower in the GBP USD spot rate after 1 year (say to 1.5000) would have been financially favourable, since the corporate needs to spend only USD 150mm to purchase the same number of GBP (100mm). Hence, if the corporate were to fix the transaction rate of GBP USD rate a year from now, it indicates the willingness to give up any potential benefits from a downward move in the rate. Of course, the benefit of a favourable fixed rate should the GBP USD rate move higher, and greater certainty of the USD cash outflow a year from now, remain advantages for this transaction.

In regard to price variability contracts, sometimes firms enter into contracts where they could be receiving a variable rate but could lower the risk overall. For example, a floating-to-floating EUR to USD currency swap keeps the coupons benchmarked to a floating rate but moves them to a currency of choice. This could lower the risk profile of the firm.

An example of a price insurance contract (USD interest rate cap) is illustrated in Figure 19.20.

FIGURE 19.20 Example of Price Variability Contract

Financing and Balance Sheet–Related Products

Using the balance sheet and the support of banking partners can provide a large set of instruments or tools to manage risk. Some of these are:

• Supply chain finance family. This family includes structured or off-the-shelf products and solutions on receivables financing, supplier financing, and so on that seek to reduce risk and provide more liquidity into the system.
• Securitisation. Removing items from the balance sheet and passing on the risk to another party while generating liquidity is common with asset-based portfolios.
• Repurchase agreements. Short-term liquidity can be generated through the use of repurchase agreements (repos).
• Embedded derivatives (into loans and investments). Derivatives can be embedded into loans or investments to generate specific profiles that can either lower the firm’s overall risk or make it take on a desired risk profile.
• Risk sharing. Especially in credit risk, agents or banking partners who share risk on a participative basis can help to mitigate portfolio exposure.

Avoidance

Avoidance of risk—not participating in a market or segment that contains risk elements which the firm is not comfortable with—remains a strategy that firms use when required. The long-term repercussions of having avoidance limits, however (i.e., putting new business or orders on hold), could create relationship issues with the other party.

Diversification or Portfolio Optimisation

Diversification involves moving the firm’s portfolio of risks to a targeted and presumably optimal mix of products across market factors to achieve a targeted degree of risk–return. Diversification generally is used in line with the concept of not putting all your eggs in the same basket and the assumption that a well-diversified portfolio of risk will yield middle-of-line returns over a period of time, making the firm generally immune to large gains should the market move in its favour or large losses in case of adverse market action. Strong analytics and models, continuous revalidation, and updating and robust systems and engine support is a must-have for firms that embark on such a strategy.

Along with each of these products comes an array of requirements for processes, valuation, reporting, and control. These are important to consider, and no product or instrument should be implemented or executed without confirming the firm’s ability to maintain it. The Toolkit section of the book (Part Five) elaborates on processes and controls.

Timing: When to Hedge?

A proactive style of management generally tracks markets and implements strategies on a regular basis. Online availability of the risk management portfolio, including mark-to-market values and transaction statues, will help dealers implement the strategies more effectively. If the firm uses an M-D-U proportion approach, the ratios and the layered hedges would have to refresh on a rolling basis every month. It might be a good practice to update the mandatory part of the portfolio within a few days of each month (top-up) without fixing the date for doing such transactions.

Ad hoc hedges or anticipatory hedges, with due approvals, can be done on a case-by-case basis.

Personnel: Who Will Hedge?

The quality of a cutting-edge policy and strategy will be high only if the people who implement it are capable of managing, sustaining, and developing the entire process. The human element (described earlier under Treasury Culture in Chapter 1), hence, is a very important aspect of risk management. Some aspects are especially critical:

• Putting the right people on the job. Recruiting good-quality talent and providing them with enough training and empowerment to be able to undertake their jobs efficiently is vital.
• Compensating dealers for performances. Given the criticality of the dealing function, it may be important to set unbiased parameters for evaluating dealers’ performance through the year.
• Establishing accountability, and roles and responsibilities. This is especially important, given the many legs and handoffs involved in the risk governance process.

RISK MANAGEMENT EVALUATION

Evaluate the effectiveness of the risk management process and include the results in the reporting and accounting process is the final stage in the IMAGE© methodology. Different metrics can be used to measure the effectiveness of the risk management process. Some of these are:

• Hedge rate against budgeted rate
• Variance of profitability from budgeted profitability
• Cost of debt
• Rate against a market benchmark (or average)
• Comparison with last year’s performance
• Comparison with a model portfolio (in case of diversification)
• VaR risk-adjusted rate
• Limit breaches
• Limit utilisation

Forecasting errors also have to be factored in.

SUMMARY

Risk management is not a one-time activity but an ongoing process that requires daily observation and activity. In this chapter, we went through one of the many models of managing risk through the IMAGE© methodology. The steps of risk identification, risk measurement, risk accounting and reporting, risk governance, and finally the evaluation of the risk management process form the core activities of the cycle.

We now set our sights on developing our understanding of practically managing risk.

1 We discuss here the IMAGE© methodology propagated and practised by independent consulting firm Aktrea Capital Pte Ltd, with whose permission the methodology has been reprinted. Although no royalty will be levied on readers who use this methodology, the company has requested that users let it know at [email protected], with a brief note on the name, address, and industry of the firm, for its own records and interest.