Chapter Twenty One
,Combining the Products to Manage Risk: Risk Governance
WE HAVE DISCUSSED VARIOUS PRODUCTS to manage risk in Chapter 20. How do we combine these products to manage risk? What are the various things we can do to manage our risk? We explore the answers to these questions and other themes of risk governance in this chapter.
We see how different kinds of risks can be managed in different situations. These risks include:
- Foreign exchange (FX) risk using spot, forward, options, and swaps
- Rate risk using the yield curve instruments such as swaps and options and longer tenor funding
- Funding and liquidity risk using long-term credit facilities and raising capital when possible
- Credit risk using credit default swaps (CDSs) and other tools
- Legal and compliance reporting using simple tools
- Operational risk, which is covered in detail in Chapter 23 and in the “Operations” section of the Toolkit in Part Five
We also introduce some basic recommended tenets and put together the pieces from the arsenal to formulate strategies in Chapter 22.
DEVISING RISK STRATEGY USING PRODUCTS
The starting point of devising a strategy for risk governance, after the risks have been identified and measured, is to frame the objectives. Once that has been done and the metrics have been finalised (see Figure 21.1), the time horizon is frozen. As has been mentioned earlier, this horizon needs to be aligned with management time horizons. Then comes the task of short-listing the possible instruments and proportions to be hedged. Two to three alternatives to the mix may be determined, since more alternatives can complicate the decision-making process.
FIGURE 21.1 Devising a Risk Management Governance Strategy
Each of these alternatives, with the mix across tenors and products, should then be tested through scenarios. This simulation, such as the ones provided by Aktrea’s ARTEMIS, can be a useful tool—something that lets the company experience what could happen under various situations. The alternatives that most match the objectives across these scenarios could be the ones that are finally chosen for consideration.
The process of deciding the final mix is a comprehensive one and a full-time activity. The simulation must be kept simple, though rigorous, with the reports conducive to decision making. Overload of information might end up hindering the decision-making process. In this chapter, we cover the use of alternatives of instruments and some of the analyses that go with prudent risk management. In Chapter 22, we evaluate a few sample strategies and weigh their benefits and potential issues.
It must be noted that no strategy or process is foolproof—some are more effective than others in certain environments and circumstances, while some great strategies can fall apart with poor implementation.
There are four basic tenets that I follow when deciding strategies and approaches to risk governance.
Tenet 1: Never Choose Products or Structures Whose Payoff You Cannot Understand
Payoff profiles are some of the most important decision criteria for any transaction. In all scenarios, the payoff has to be within the framework, loss norms or return ranges as per the policy and need. While it may not always be possible for the Treasurer to understand how the product has been structured, he or she must know what it does. I used the example of the car earlier: We may not know the details of the engineering and technology that goes into the car, but we need to know how to drive it and how it responds at various speeds, on various track and road conditions, and if it gives us the mix of fuel efficiency, comfort, appearance, and ease of driving and maintenance that fits our requirements.
Tenet 2: Choose Products That You Can Price (at Least Approximately)
Pricing for most products and market levels, with information systems such as Thomson Reuters Eikon, is generally available. For simple products, especially forwards and simple options, data are now available for many currencies. Hence, most simple products can be priced easily with the right tools. The ability to determine the price of a structure on one’s own cannot be the exclusive domain of a structuring specialist on a banking markets desk. A structure that is very complicated is priced using models or complex pricers. The complexity of the model is generally commensurate with the complexity of the product. Not knowing how to determine the basic price of the product usually indicates that it is more complex, with possibly more opacity and less liquidity,
Tenet 3: Decide Up Front Who Bears Cost of Hedging
The allocation of the market rates to various units has to follow a set of guidelines to prevent disputes at a later time on possible preferential treatment by Treasury to certain units. Especially on days of high volatility, two transactions done minutes away from each other could have very different rates. Prior agreement on the distribution of rates to each unit—a good transfer pricing method—will remove any ambiguities and uncertainty around the rates.
Tenet 4: Use Simulation, but Wisely
Simulation is a very strong method to decide the best strategy to use and also to revalidate strategies midway and prior to review dates. Two caveats come to mind:
USING PRODUCTS TO MANAGE RISK
In Chapter 20, we examined various products and tools and discussed briefly how they could be employed. Here we run through, risk by risk, possible exposures and how products and instruments can be used to manage each kind of risk. Table 21.1 provides an overview of the arsenal of products available to global treasurers to manage market risks. Not all products are available in all markets, and many require counterparty risk limits with banks. Similarly, we look at tools to manage credit risks and liquidity risks later in the chapter. The darker shading implies more frequent use, while the lightly shaded cells depict possible but less frequent use of tools for each situation or risk.
TABLE 21.1 Arsenal for Market Risk
In order to judge tools and strategies as successes or failures, they have to be tested over time and implementation. Well-thought-out conservative policies and strategies with well-defined objectives and unambiguous structures, consistently applied over time, are more likely to see positive results. Successes or failures of well-thought-out strategies cannot be declared after one or two beneficial or adverse results; their efficacy over a longer time frame is a better yardstick to judge them by.
Foreign Exchange Risk
The FX arsenal has possibly the most weapons, which range from the simple to extremely complicated. Cash flows such as sales and expenses, and translation items can be generally hedged using FX forwards or options.
To manage the FX risk of debt, especially principal, principal-only swaps (POSs; effectively forwards with premium payments in intervals) can be appropriate tools. FX risk of interest payments can be handled through coupon swaps.
Diversification of portfolio across currencies can also be a useful tool—subject to the selection of a conservative portfolio, regular reassessment, and consistency.
Interest Rate Risk
The tools to manage interest rate risk are also quite varied and can handle the many interest rate risks that fall into the treasurer’s ambit. These include:
- Price (rate or benchmark movement). Interest rate swaps, quantos, or options (caps, floors, and combinations) can be used to handle specific benchmarks or price risks.
- Yield curve risk. Swaps or products to handle yield curve shapes can be structured to enable the Treasurer either to reduce variability or to benefit by taking a view on the yield curve steepening or flattening.
- Reinvestment/rollover. Rate locks, forward rate agreements, or options can be used to lock in rates either forward or for longer terms. There could be some residual risk, especially on credit spreads, that can also be hedged using CDSs of peer groups.
- Residual basis risks and other risks. These also can be addressed through specific tailored over-the-counter (OTC) swaps. Diversification can be used to find optimal or lower pricing depending on objectives and focus.
Table 21.2 shows some of the cases where products could be used for cash flow hedging.
TABLE 21.2 Cash Flow Hedging
Other Risks
Commodity and equity risks are managed through OTC or index futures and derivative contracts. They can also be embedded into swaps, loans, or other contracts. Especially for commodities, fixed price purchasing contracts may be a good alternative for long-term visibility—where the supplier takes on the risk (and passes on the cost in some cases) to the company.
FIGURE 21.2 Structured Interest Rate Swap
A case of structured interest rate swap that provides management of two factors in one transaction, is given in the next case study.
Equity or commodity-price linked derivatives transactions can also be embedded into loans.
A disadvantage of embedded derivatives in a conservative accounting environment is the massive increase in accounting work (to potentially strip the derivatives and the underlying asset or liability, get different MTM levels and possible inability to get hedge accounting treatment on such structures).
CREDIT RISK
An overview of tools used to manage credit risk is given in Figure 21.3 The darker shading implies more frequent use, while the lightly shaded cells depict possible but less frequent, use of tools for each situation or risk.
FIGURE 21.3 Tools to Manage Credit Risk
The CDSs described earlier remain the most common tools for hedging credit risk. However, liquid CDS pricing is generally available only for large entities that have issued bonds. For countries that do not have a developed CDS market, nondeliverable forwards (NDFs) can could be used as proxy hedges if the related risks on the proxy hedge itself are borne in mind (i.e., a credit event may not trigger a sale on the currency, the currency itself could strengthen with no credit event, thereby increasing the cost of the hedge, etc.).
Other related methods, such as credit insurance and factoring, can be used to manage credit risk. Increasingly, the use of supply chain finance tools has taken on more and more importance with the increasing role of banks as service partners across the supply chain.
Cash collateralisation is one method that could work, especially if the customer is much smaller and is willing to help reduce risk to an extent.
Avoidance comes with related long-term issues since it usually means staying away from a market or customer for a period.
Diversification has historically been a prudent exercise, provided it is done consistently and the diversification aspects are thought out and analysed.
LIQUIDITY RISK: BALANCE SHEET AND ASSET-LIABILITY MANAGEMENT
Figure 21.4 provides a snapshot of the tools to manage liquidity risk. As with the tools for other risks provided earlier, the darker shading implies more frequent use, while the lightly shaded cells depict possible but less frequent use of tools for each situation or risk.
FIGURE 21.4 Tools to Manage Liquidity Risk
We have already mentioned that the key to a good liquidity risk management strategy is to have:
- Cash
- Reliable access to bank credit lines
- Assets that can be repurchased (or “repo”-ed or liquidated under most circumstances)
The figure matrix elucidates some of these strategies in detail.
When there is a systemic liquidity problem, treasurers must decide whether it is better to utilise some of the credit lines or facilities for long-term borrowing when a crisis looms. The related costs and changes to balance sheet, should there be no crisis, can prove to be a problem.
USE OF ANALYSIS
Many tools are available to the Treasurer to analyse and make decisions on market levels, next steps, and future situations. We discuss a few of them here.
Fundamental and technical analysis seek to determine values of market factors or firm performance through different means. Scenario analyses help to rationalise thoughts on the risk management strategy, while payoff profiles help to ascertain the applicability of a set of tools to manage particular risks.
Fundamental Analysis
Fundamental analysis assesses the health an economy, market, industry, or company through detailed study of its various constituents, environments, dependencies, competencies, and markets with the objective of making financial and market-related decisions. Fundamental analysis can be of three types:
Technical Analysis
Technical analysis is a technique to forecast the direction of market prices by studying historic data on movement and volume of prices. Technical analysts believe that information required to forecast future price movements has already been reflected in historical movements of the factor. The underlying assumption is that the collective behavioral response of market participants to price movements results in patterns that are recognisable—this makes changes in trends or any other move follow a sentiment change that is predictable.
Hence, technical analysis is more concerned with extrapolating information from existing price patterns and less concerned with the actual price of a market factor.
Figures 21.5 and 21.6 show typical series of technical analyses using available tools from Thomson Reuters Eikon.
Simulation
As described, simulation uses take a set of exposures through various scenarios and considers the impact of those scenarios over time. At various points, the simulator system also allows the risk manager to make decisions that would lead to further possibilities that can be captured.
Simulation provides a real-life feel to actual data and simulated situations: What if this event happened? What if this client went under? What if cost of borrowing shot up? What happens to my balance sheet and financials—what is the cost of borrowing and cost of capital, and how do they affect my ratios?
Simulation is an invaluable tool as long as the subjective elements are thought through and there is no data overload. The more complex the simulation becomes, the more decision points there will be and the more decisions there are to make.
Simulation also allows the Treasurer to superimpose hedges on a portfolio, watch the performance of the hedging strategy over time, make changes midway, and reassess what might have happened had the changes not been made. This method gives the Treasurer a good feel of what the strategy might evolve into in the company’s financials.
More details on simulation may be found on the book’s Website www.wiley.com/go/treasuryhandbook or at www.aktrea.com.
Payoff Profiles
Payoff profiles are, in my view, a must-have for deciding any product, especially when comparing two products. The payoff profile can be in chart or graphical form. A graphical payoff profile from an ARTEMIS simulation for a EUR USD decision is provided as a sample in Figure 21.7. The firm, after having started hedging through vanilla options, debated various scenarios, including leaving the rest of the portfolio unhedged or covering fully through forward. Finally, based on the firm’s objectives and a corresponding possible trade-off between certainty and opportunity loss, a decision can be made.
FIGURE 21.7 Sample Payoff Profile
OPERATIONS AND TECHNOLOGY RISK
The aspect of operations management and its risk are detailed in Chapter 24 in Part Five. Avoidance is the primary method for managing operations risk, and all efforts on operations and technology risk management is geared towards preventing any outage or error. Increasing control and rigor of process backed up by automation and integration reduces the probability of occurrence of this type of risk.
LEGAL AND COMPLIANCE RISK
Managing legal and compliance risk on the balance sheet and capital side of things is a critical activity for the Treasurer. While every company has different processes to manage these risks, a sample set of processes and checklists could be the best way to address these. A more holistic compliance management methodology through automation is provided in the next case study.
FIGURE 21.8 Zero-Based Functionality Specifications for a Compliance Management System
FIGURE 21.9 Functional Specifications
TABLE 21.3 Some of the tangible cost elements were:
| No. | Item | Cost |
| 1 | Platform (existing MS SQL 2008,. Net framework platform and Crystal Report Writer 2008) | |
| 2 | Cost of developers’ effort (4 man-months) | Rs. 400,000 |
| 3 | Cost of design and development relating to additional features | (Rs. 40,000) |
| 4 | Training | (Rs. 50,000) |
| 5 | Testing and piloting | (Rs. 100,000) |
| 6 | Master data compilation | (Rs. 200,000) |
| 7 | Total cost of ownership | Rs. 790,000 |
TABLE 21.4 Tangible Benefits
| No. | Item | Cost |
| 1 | 5% saving through productivity increase of work force using tool per month = 20 × 50,000 × 5% = Rs. 50,000 × 12 = | Rs. 600,000 |
| 2 | 5 man-days saved on account of compiling information per month: Rs. 2,280 × 5 = Rs. 11,400 × 12 = | Rs. 136,800 |
| 3 | Difference in penalties paid in previous year—penalties paid in first year of operations = | Rs. 400,000 |
| Total savings = | Rs. 1,136,800 |
- Cost Effective
- Automating the system saves a lot of man-hours for follow-up
- Lesser penalties due to real-time monitoring
- Zero tolerance against noncompliance
- Real-time clarity in the compliances relating to the organisation
- Responsibilities are clearly defined and monitored accordingly
- Employee profile management
- Easy-to-manage change
- The organisation is connected with respect to compliances
- Controlled Legal Exposure
- Not all documents are accessible to everyone and hence risk is controlled
- Increased Productivity and Confidence
- More time spent in doing value-added work rather than follow-ups and reminders
- Senior management confident of one-time compliance and has full visibility
- The implementation period: around five months
FIGURE 21.10 Department-wise Checklist, Functional Head-wise Checklist
FIGURE 21.11 Compliance Index
FIGURE 21.12 Monthly Compliance Report
FIGURE 21.13 Recurrence Calendar
FIGURE 21.14 Compliance Dashboard
SUMMARY
Management and governance of risk is a set of deeply involved, effort-intensive, and time-based activities that requires rigor, discipline, and maturity to implement and sustain over a long term. Unfortunately, there is no one right answer, no one ideal solution. Each company, with its own individual DNA, management views, risk appetite, and market dependence, has to identify and sort out its own governance structure. The company’s risk strategy will evolve over time and grow with the company’s needs performance and risk profile. This chapter summarised some of the tools and resources to manage risk, with a case study on managing compliance risk, which tends to be an understated and under-covered element of a company’s risk profile.