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.
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.
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.
The classical definitions or classifications of risk are:
These have been summarised in Figure 17.1
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:
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 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.
The following note highlights how a seemingly simple investment could also go wrong.
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 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.
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.
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 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.
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:
We cover the area of operations and control processes in more detail in the Toolkit in Part Five.
Event risk comprises these possible areas:
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.
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.
Classification | Risk | Some Examples |
By point of origination | Externally driven | Market risk Credit risk |
Internally driven | Operational risks Funding liquidity risk |
|
By cause or relevance | Environmental causes | Country-specific risk Cross-border risk Market liquidity risk Systemic risk |
Process causes | Funding liquidity risk Operational risk Reputational risk Legal risk Compliance risk Technology risk |
|
When dealing with other entities | Supply chain disruption Credit (counterparty risk) Cross-border risk Liquidity risk Legal risk |
|
Event or probability of occurrence-related | Project/contingent risks Credit default risk Corporate action |
|
Financial Impact | Transactional Translational Economic/valuation |
|
By immediate consequence | Reputation | Reputational risk |
Financial | Financial risks | |
Legislation | Legal risk Credit 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.
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.
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.
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.
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.
Year | Crisis |
1987 | US market issue |
1990 | Collapse of junk bond market |
1991 | Oil price surge |
1992 | European Exchange Rate Mechanism (ERM) crisis |
1994 | US bond market crash |
1995 | Mexican crisis |
1997 | ASEAN crisis |
1998 | Russia |
1998 | Long Term Capital Management (LTCM) crisis |
2000 | Dot-com bubble |
2001 | Payment disruption post-9/11 |
2002 | Argentina |
2008 | Liquidity crisis/LIBOR issue |
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.
Some of the various styles of risk management are indicated in Figure 17.4.
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.
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.
Locational aspects of risk are provided next. Table 17.3 illustrates these risks.
Location | Aspects Impacted |
Company (headquarters) | Currency of the balance sheet Funding requirements Tax aspects Accounting treatment Regulations Use of cash Investment and other critical aspects |
Subsidiaries | Funding cost Liquidity Reparability Cross border FX risk |
Customers | Currency of sales Market practice on receivables and credit period impacts balance sheet and hence funding requirements |
Suppliers | Currency of purchases Availability of supply chain financing and credit facilities for suppliers Payment practices also determine length of credit period extended by suppliers and hence funding requirements |
Invoicing | Tax Exchange Companies are increasingly selecting the location of invoicing to improve the risk and cost profile of invoicing |
Inventory and Manufacturing | Translation issues Funding cost Liquidity-related matters |
Treasury | Centralised treasuries or regional treasury centres have a better perspective on risk Contribute towards concentrating the risk and balance sheet elements in fewer locations |
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.
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.
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.
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.
Inventory across currencies results in translation issues as well as funding-cost and liquidity-related matters.
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.
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.
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.
The ability to bargain with customers and suppliers and to negotiate terms favorable to the firm is an important source or mitigate of risk.
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.
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.
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.
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).
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 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.
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.
Which do you think is the most volatile currency in Figure 17.9, A, B, or C?
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.
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).
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.
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.
Two terms are often used interchangeably, and this practice might not always be correct. We clarify in the following note.
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.