Chapter Twenty Two

Risk Management Governance Strategies

A RISK MANAGEMENT GOVERNANCE strategy—which covers the governance aspect in the company—consists of many elements. In this chapter, we discuss some of the strategies, with illustrative examples. In our discussion, we use the M-D-U (mandatory-discretionary-unhedged) proportion across each and provide a summary of each strategy with descriptions of the layering in practice.

KEY ELEMENTS OF THE GOVERNANCE STRATEGY

Some of the key elements of the governance strategy have been described in Chapter 19. To recap, these are:

• Objectives
• Scope and risk factors
• Time horizons and tenors
• Amounts
• Tools and methods
• Timing
• Personnel

Objective

The objective of the risk management activity has to be defined up front. This is important since the selection of the entire mechanism for the governance will be based on this definition.

Scope and Risk Factors

The focus for each class of risk is the specific market factors and measures that will be managed for that asset class. The focus determines what to hedge—the scope and the risk factors to hedge.

Time Horizon and Tenor

The scope of the risk being measured in terms of time sets the tone for the focus, measurement, and management of the various risk elements. Sometimes these risks could be different for different asset classes. Some treasurers may also choose to look at different time horizons for different types of hedging—for example, focus on stability and visibility of cash flows in the one-year horizon while looking at lower cost of capital in the five-year horizon. The more dispersed the time horizon and objectives, though, the more complicated the entire risk management process becomes. The attempt to do too much can backfire, and sometimes it is better to start with small objectives and then increase complexity.

To aid the proportion and to make it more implementable, the tenor limits by year put in a maximum ratio for each particular year’s exposure that can be covered at any point of time.

Amounts

The proportion for hedging or risk management should be identified. It generally can be a combination of mandatory (M), discretionary (D) and unhedged (U) portions of the portfolio over the time period being discussed. The percentage of M and U stipulates the minimum percentage of the portfolio that must be covered and left open respectively. A 100% discretionary proportion is the most flexible, since it assumes a portfolio that can be even 0% covered or fully covered at any point. Limits are also put in place to ensure that the amounts covered are commensurate with the policy and view of the firm.

Tools and Methods

The tools for risk management specify the specific instruments or products that are used to manage the risk.

Prior to deciding which strategy to recommend for approval, the Treasurer would do well to run simulations using various scenarios with some short-listed strategies. In the sample Treasury policy in the appendix of the Handbook, these elements are depicted.

Timing and personnel will also play important parts of the governance structure.

Next we briefly discuss three sample strategies. Note that none is recommended by the author. They are provided only for the purposes of illustration, to show some thought processes and approaches that can be put into practice.

SAMPLE STRATEGY A

Strategy A (summarised in Table 22.1) is a simple strategy that focuses on short-term visibility. On the foreign exchange (FX) side, it deals with receivables and payables in one currency pair each (USD JPY and EUR USD respectively) and seeks to mandatorily hedge any identified on-the-book exposure forward. There is no unhedged booked exposure. This method might be very effective if the time horizon for such cash flows is reasonably long. If the items are booked a few months before they become due, the effective time horizon for hedging becomes those few months, since any unbooked exposure up to a year is still left uncovered.

TABLE 22.1 Sample Risk Management Strategy: Strategy A (Simple “On-Book”)

On the interest rate risk side, the company hedges its exposures for the year through an interest rate swap (IRS), where it receives a floating rate (which it ultimately pays out on its working capital) and pays a fixed rate. The company is comfortable to live with a basis risk and a timing risk (since it will not be borrowing or setting the London Interbank Offered Rate [LIBOR] for its working capital loans on the date of the IRS floating rate fixing, and sometimes it will not use the 3m USD LIBOR as the benchmark for the interest of some of its working capital loans).

The company does not have significant commodity or equity risks.

On the credit risk side, the firm prefers to manage its credit risk by diversifying its customer base. Hence, it tracks its top three customers to not be more than 30% of its overall revenue. The firm goes as far as using avoidance—by not quoting to its top customer should the total exposure to the top three exceed 30%. The firm does not measure or track its pre-settlement exposure of derivatives and hedges or even its deposits with its banks as a source of credit risk, since the firm does not have large cash surpluses and the short-term nature of its hedges, in management’s view, does not create material mark-to-market (MTM) variances to include in its risk management. Also, the firm is happy with its two banks and does not seek to maintain banking relationships beyond those, which have provided it with support through its existence.

Finally, the company provides for liquidity situations by targeting at least 20% of its funding need in liquid assets that can be sold to generate liquidity and 20% of its needs through committed but unutilised funding facilities from its two banks. This provides the firm the comfort of having 40% of its funding needs met should there be a liquidity crisis. The success of the strategy will be determined by the ratification of the firm’s assumptions on the continued ability to sell its 20% liquid assets if required, along with the valuation of those assets at that point, and on the assumption that the two banks will be able to provide the liquidity committed in times of crisis.

SAMPLE STRATEGY B

This strategy (summarised in Table 22.2) uses a slightly longer time frame and correspondingly more tools to manage risk. Typically the strategy would be used by a larger group of companies with more exposures than the one in Strategy A.

TABLE 22.2 Strategy B (Long-Term Layered)

The group is headquartered in Europe and hence denominates its consolidated financials in EUR. The group has described its hedging objective as lowering the variability of its financials and has designed its strategy over a three-year horizon.

On FX, the strategy seeks to focus on transaction risk in its revenues around the world, denominated in different currencies, as well as its purchases that are largely USD based. Translation risks for all individual items over 50 million EUR in notional value have also been included. The group seeks to follow a 40–30–30 M-D-U strategy of layered hedging, with a cap of 100% for year 1, 70% for year 2, and 40% for year 3. Hence, in a maximum allowable hedge scenario (40% mandatory + 30% discretionary), the firm would have hedged a maximum of 70% of its exposure across the three years (depicted in Figure 22.1).

FIGURE 22.1 Layered Hedging Proportions for Strategy B

The instruments used in this strategy are a combination of FX forwards and vanilla options; the caveat is that the group designates all its transactions as cash flow or balance sheet hedges as per accounting policy, and hence each transaction would need to be an effective hedge. This necessitates huge teamwork between the Treasury and the control teams and also good systems to track and account for these transactions.

On the interest rate side, the group seeks to average out the potential moves across rates (and currencies in case of non-EUR debt) by fixing half of its debt cost (including the effect of currency changes on net principal repayment in EUR). The group effectively manages this through swaps back into EUR and into fixed rates where possible.

Commodity exposure (on CPO) is managed through combinations of OTC transactions customised to the notionals and dates of the underlying exposure in order to derive maximum accounting effectiveness on the hedge.

Credit exposure is tracked actively for customers and banks (for deposits). Where customer exposure is over 5% of total sales, tools such as CDSs or receivables financing is used to manage the exposure, where possible. Similarly, CDS or NDF (as a proxy hedge) is used to hedge potential cross-border risk for countries with exposure over 10% (from a sales perspective). For bank deposits, the limit method is used where not more than 25% of overall available cash is placed with any banking group on a consolidated basis. The group prefers to use banks exclusively for risk management owing to their specific capabilities and service levels in this area. Hence, operating accounts, cash management, etc., could be done through other banks. Pre-settlement risk, though, is not managed actively. MTM exposure by the banking group is provided to management on a regular basis to enable any ad hoc decisions on risk concentration to be taken.

Liquidity risk is managed and mitigated through the use of a liquidity buffer of 15% cash in EUR terms and 20% liquid or repo-able assets, with unutilised but committed facility of 15% each from two banks being used.

This strategy is layered and balanced but not comprehensive. It does assume some element of system automation and integration.

SAMPLE STRATEGY C

Strategy C, depicted in Table 22.3, is a more aggressive and revenue focused one where Treasury acts as a profit centre. Here the objective is for Treasury to contribute to an increased profitability of the firm, where financial risk is taken within parameters authorised in order to generate profit.

TABLE 22.3 Strategy C

In this case, all the business risks are managed by Treasury and transfer prices are passed on to business as per a pre-agreed plan; for example, prevalent forward rates at the beginning of the planning period (say one year) can be used. All further risks thereon (and returns) are to the account of Treasury.

Hence, the scope of the risks as would be detailed in the policy, including limits on each market factor, concentration, and other items would be detailed, even if that item is not directly linked with the market risks specifically linked to the business (i.e., either specific risks assumed by Treasury or residual risks managed by Treasury). For example, if the company is net long EUR (e.g., it has more euro receivables), the Treasury could take a call to move, within approved parameters and limits, to an overall short position in EUR should it have a negative view on that currency.

On the interest rate risk side, the group looks to use the balance sheet to lower overall cost of borrowing. This could include moving debt to a third currency different from the original currency or the base currency (GBP). This is a high-risk, high-return strategy, with the group retaining the ability to use embedded options to manage or mitigate risk.

Commodity and equity risks are managed actively using available products. Credit risk is also managed actively, with the evolution being the use of credit limits for pre-settlement risk, and hence including negative MTM values along with the deposit or investment amounts to compute net exposure with a bank. Regarding liquidity risk management, the group has moved towards diversification of the buffer across currencies.

We now look at a case of a company owned by a private equity firm, whose risk management strategy went through some transition.

STORYBOARD: WHOSE PERSPECTIVE?

And so it happened that the private equity firm PEX, which had turned around the operations of investee company ICX, had reached that time in its relationship with ICX when it was looking for sellers or, better still, the gold mine of the initial public offering (IPO). Over the past five years, PEX had invested time, money, talent and resources to ensure that ICX, a manufacturing firm, had gotten its act together. Costs were slashed, economies of scale were achieved and the firm had grown from a small player to a serious contender in the markets in which it operated. The one area that ICX had not focused on was the management of its foreign currency risk. Given that most of its manufacturing was in emerging markets with locally procured components (which meant that 60% of the firm’s expenses were in emerging market currencies), the dollarised enterprise was facing its toughest call yet—whether it should continue with its generally laissez-faire risk strategy or not (see Figure 22.2).

FIGURE 22.2 Laissez-Faire Approach to Risk Until Now

The management of ICX, largely recruited and placed by PEX (the 100% shareholder), had hired a full-time Treasurer to relieve the CFO. After much brainstorming and analysis, a layered hedging strategy of 30–30–40 (M-D-U) was decided on, and the risk policy was about to be rewritten. Other industry players usually managed their short-term risks aggressively, but a few had gone out longer term. The time horizon that ICX had planned to hedge was around two years, which was generally the period around which the firm had reasonable visibility and perspective (see Figure 22.3).

FIGURE 22.3 ICX’s Proposed Strategy

Then came the thunderbolt. Emerging market currencies had weakened considerably (see Figure 22.4), and the principals at PEX, with a potential IPO looming large, wanted to lock in the exposure to emerging markets currencies at these levels—and out to three years!

FIGURE 22.4 Emerging Market Currency Moves

Source: Thomson Reuters Eikon

From the perspective of PEX, the idea of locking in the rate at historically good levels carried strong favour; if the plan was to exit in the next few quarters, FX risk would be taken out of the equation. The proposed strategy is depicted in Figure 22.5.

FIGURE 22.5 PEX’s Proposed Strategy

The CFO was in a bind: The opportunity loss of locking in cash flows up to three years looked quite enormous, as did potential MTM volatility since the firm was not set up to implement hedge accounting. The economic rationale of PEX’s proposal was reasonably sound, as was the overall impact and visibility of cash flows on an economic basis.

Which view would prevail? Was the company being put at risk since no peer firms were fully hedged? Or were shareholder interests being best preserved by locking in a historically good price with the objective of good valuation?

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SUMMARY

In conclusion, different strategies can be formulated based on the inputs. In this chapter, we covered three sample strategies in detail. These strategies use the tools provided in Chapter 21 with the DNA of the firms and the market environments in which they operate.