Financial Risk Management: Prof. Ian Giddy

SIM/NYU The Job of the CFO
Financial Risk Management

Prof. Ian Giddy
New York University
Risk Management is a Process
Corporate Risk Management
Define
Measure
Manage
Monitor
Copyright 2001 Ian H. Giddy
giddy.org
Financial Risk Management -5
Financial Risk Management

Why does it matter? Why and when should we hedge? What should we hedge? How should we gauge exposure?

Financial risk management must be tied to the companys business
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The Case For Hedging

Company has special information Company has special market access Secure cash for investment opportunities Reduce potential costs of financial distress, increase debt capacity, and reduce expected taxes Since currency matching reduces the probability of financial distress, it allows the firm to have greater leverage and therefore a greater tax shield.
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Optimal Capital Structure

VALUE OF THE FIRM
HEDGING CAN REDUCE COSTS OF FINANCIAL DISTRESS
ALL-EQUITY VALUE
DEBT RATIO
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Hedging, Valuation, Taxes and Financial Distress

Negative net worth Positive net worth Profile of return to creditors + Costs of bankruptcy to creditors
Distribution of net worth with hedging Distribution of net worth without hedging (or with greater exchange rate volatility)
Net worth of the firm

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When Should Firms Hedge?

Business risk
Financial risk
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Which Firms Should Hedge?

Characteristics of firms for which financial stress is especially costly: Firms with:
Products
that require after-sale servicing Products whose quality is difficult to determine in advance Products with high switching costs Products that rely on third-party servicing
And firms that have:

High-growth
opportunities Intangible assets like firm-specific human capital Large excess tax deductions
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What Exposure Should Firms Hedge?

Currency
risk
Transactions Translation
exposure Economic exposure

Interest
Rate Risk Commodity Price Risk
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Measuring Market Exposure

Defining corporate exposure: How will my companys value be affected by market price fluctuations? Types of exposure
Transactions Balance
sheet/portfolio Economic
A risk management framework
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How Effective is My Companys Risk Management? Warning Signs:

Dont measure risk No linkage of risk to value No effort to anticipate Lack of business risk policy
Fragmented effort Narrow focus Poor risk communications Lack of an integrated risk assessment framework
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Formalize Risk Management Policy and Control Framework

Develop an outline of a policy statement, or recommend improvements to existing document
Benchmark controls versus best practice using the Group of Thirty Recommendations, Treasury Management Association Guidelines, or accumulated knowledge of appropriate practices
Assess centralization issues related to financial risk management and treasury design
Define
Measure Manage
Monitor
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Identification and Definition of Financial Exposures

Goal: To identify significant financial risk exposures and prioritize them in a manner consistent with management's desired risk profile.
Translation Exposure, Transaction Exposure, and Economic Exposure Long-term versus short-term exposure Intracompany versus third party exposure Cross currency exposure Competitive exposures Absolute Rate Risk, Convexity, Basis or Correlation Risk Short-term liquidity portfolio Investment portfolio Capital markets borrowing Leasing portfolio Price Risk, Basis or Correlation Risk Procurement Inventory Sales elasticity
Currency
Interest Rate
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Commodity
Market Risks: Definitions
Three Views of Market Price Risk:

Transactions
Balance
Sheet/Portfolio Economic risk.
giddy.org
Market Risks: Definitions

Transactions
Balance
Transactions Exposure
Sheet/Portfolio Economic risk.

Portfolio Exposure Economic Exposure
giddy.org
Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain date
Example:
If Nokia invoices a NTT of Japan in Japanese yen for a celphone shipment then the firm has Japanese yen exposure and can hedge this by borrowing yen. This kind of exposure is readily hedgable using forwards, futures or debt
giddy.org
But Transactions Exposure Can be Misleading...
Portfolio Exposure
Economic Exposure
Austin Computer purchases notebook computers in Taiwan for sale in the US. Austin must pay in NT$. Should it hedge its anticipated payments for 1996?
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Austin Computer
NT$
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Interest Rate Risk: Portfolio
Portfolio Exposure
Economic Exposure
Portfolio risk: interest rate fluctuations can affect the value of a bond investment portfolio Bond price fluctuations will affect the balance sheet Can be hedged, using duration as a risk/sensitivity measurement tool Can be hedged with futures, bond options, and swaps.
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Pepsico Pension
Assets (each $10m):

1-year
Pension liabilities:
$10m
E$ deposit 5-year, 6% T-note D=4.6 10-year Strip
3 years $10m 5 years $10m 7 years
What
is Pepsico pension funds risk?
Duration
of the assets (+ve) Duration of the liabilities (-ve) Net duration is the risk to be hedged!
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Value at Risk: SantosBank

INSTRUMENT
SANTOSBANK POSITIONS ($1,250,000) ($100,000) $450,000 $120,000 $120,000 $120,000
30 day 90 day 180 day 1 yr 2 yr 3 yr 4 yr 5 yr 7 yr 9 yr 10 yr 15 yr

NET TOTAL
$1,120,000
$0
$0
$0 ($420,000) $0 $160,000 $3,700,000
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Asset and liability positions for a Brazilian banks New York branch. What risk does it face?
BIS: Minimize Value at Risk

INSTRUMENT SANTOSBANK POSITIONS ($1,250,000) ($100,000) $450,000 $120,000 $120,000 $120,000 $1,120,000 $0 $0 $0 ($420,000) $0 $160,000 $3,700,000
30 day 90 day 180 day 1 yr 2 yr 3 yr 4 yr 5 yr 7 yr 9 yr 10 yr 15 yr

NET TOTAL
+ =
Value-at-Risk
Mean
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Market Price Risk: Economic

Economic
risk arises from the real business risk of the company, insofar as it is tied to market interest rates, FX, commodity prices It affects the shareholder value, but may be difficult to quantify Hedging may require tailored solutions
giddy.org
Inmet Mining Corp.

In 1994 Canadian mining company Inmet bought 48% of Bougrine, a lead & zinc mine in Tunisia. Inmet had to borrow $33 million at a floating rate. Should it hedge its cost of funds? Answer: Business exposure is to lead & zinc prices (mine shutdown in Oct 96 because of low zinc prices) Hedge with digital option linking cost of funds to lead & zinc prices
giddy.org
Market Price Risks: Summary


Transactions
- lock in
forward rate Portfolios

Avoid
duration mismatching Minimize Value at Risk

Economic
risk - business sensitivity to market prices.

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Most Important Objective In Using Derivatives To Hedge

Market Value of the Firm 8%
Volatility in Earnings 42%
Volatility in Cashflow 49%
Balance Sheet Accounts 1% giddy.org
CIBC Wood Gundy/Wharton 1995 End-User Survey Most Important Objective In Using Derivatives To Hedge Financial Risk Management -29
Next Step: Analyze Current Exposure Measurement Techniques

Precision of the data
Risk Information Sources:

Current trade flow data Portfolio system reports Accounting information Budgeted trade flow data Pricing practices
Time horizon of the projections Frequency of reporting
Quantification Adequacy
giddy.org
Corporate Exposure Information Sources

Current trade flow data
Portfolio system reports Hard Accounting information
Exposure Database
Budgeted trade flow data Soft Economic exposure estimates

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Exposure Database: Example
Exposure Database
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From Data to Analysis
Exposure Database
Exposure Measurement System

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A Management-Friendly Report
An example is FourFifteen, named after J.P. Morgan's market risk report produced at 4:15 p.m. each day. The "4:15 Report," a single sheet of paper, summarizes the Daily Earnings at Risk for J.P. Morgan worldwide.
Gov't Bonds Zero Cashflow
Portfolio Risk Simulation

RiskMetrics
USD Base. Vols. & correls. as of May 04, 1995.

AUD BEF CAD DKK FFR DEM

ITL JPY NLG ESB SEK CHF
GBP
XEU
USD
Total 37
1 Mo 3 Mo 6 Mo 12 Mo 2 Yr 3 Yr 4 Yr 5 Yr 7 Yr 9 Yr 10 Yr 15 Yr 20 Yr 30 Yr
-200
15 20 25
22 -30

160 -5 -105
- 50 20 - 105 0 0 0 0 0 0 0 0 0 0 0
($000)
RISK
Equity
Implied
- 196.1 - 196.1
59 23
22
-29
54
-145 23 -122
FX
Spot
Net
82
22
-29
Int.
Eq.
502
262
139
400
740
Fx
5,048 -200
4265 -347 4181
1383 -6 1383
1820 -83 1876
8516 -451 400 8805
divers.
Net
5,350
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Exposure Report: Example
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Market Risk Measurement

Where are we now? Where do we need to be?
Option Sensitivity Measures Value at Risk
Distribution of market moves and portfolio values Includes market correlations Reprice portfolio Aggregate risk measures within confidence interval
Volumetric Duration/ PVof01

Notional Amounts
Simulations
Non-linear risk Limited market Linear risk measures scenarios that measures could include Swap/ bond Delta, gamma, vega, theta, rho market equivalents No aggregation of correlations risk measures Reprice portfolio across asset Parallel and nonclasses or parallel curve instruments shifts Aggregate portfolio risk per scenario
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An Overview of Corporate VAR

Business 1
Transactional Database Portfolio Database

Projected Revenues
Business 2
Business 3
Projected Operating Costs
Estimates of Cash Flow Distribution
Base rates/ Currency market conditions Volatilities Correlations
Model 1
Interest Rates
Model 2 Mean
Equities
Model 3
Commodities
Historical rates/ Discrete scenarios Model 4
Impact on Earnings
Currencies
giddy.org
Analyze Exposure Management Activities

Investigate opportunities for natural offsets Evaluate alternative hedging techniques Multicurrency borrowing/ investing, currency of invoice, & commercially-based hedging techniques
Financial instruments such as forwards, futures, swaps and options
Cost/benefit analysis
Expected and out-of-pocket costs, benefits and risks of potential strategies; competitors actions Accordance with overall corporate policy and acceptable from an accounting and regulatory standpoint, if applicable
giddy.org
Strategic alignment
Corporate Exposure Management: Match Tools to Risks

Current trade flow data Inflexible, committed
Hard
Portfolio system reports
Accounting information
Budgeted trade flow data Economic exposure estimates

giddy.org
Flexible, optional
Soft
Most-Used Instruments Hedge Identifiable Exposure
70% 60% 50% 40% 30% 20% 10% 0% Forwards Swaps OTC Exchange Struct. Options Options Type of Transaction Der.
Foreign Exchange Interest Rates Commodity Futures Equity Hybrid Debt
Source of Exposure
1995 CIBC/Wharton End-User Survey
giddy.org
Market Views Impact Corporate FX Hedging Decisions

80%
70%
Sometimes Frequently
60%
50%
61%
40%
48%
30%
33%
20% Wharton/ CIBC Wood Gundy 1995 End-User Survey: 6% Frequency With Which a Market View Impacts FX Actively Derivatives Take Transactions Positions Financial Risk Management -42
10%
11%
0%
12% Alter the Size of Hedges

giddy.org
Alter the Timing of Hedges

Sources of Corporate Financial Risk

Uncertain Markets
Uncertain Exposures
Risk!
Mistaken Views
Wrong Risk Measurement Methods

giddy.org
Monitoring and Control

Uncertain Markets
Monitoring implies performance measurement
Performance measurement is the science of attribution

Performance measurement requires a benchmark Surprises require reassessment and response
Uncertain Exposures
Risk!
Mistaken Views
Wrong methods
Define
Measure Manage
Monitor
giddy.org
Evaluate Management Reporting and Risk Management Monitoring Process

Senior Management
Independent Risk Management/ Internal Audit
Limits & Benchmarks Exposure Information

Management reporting and focused performance measurement are necessary to identify problems with the current risk management strategies
Financial Product Information

giddy.org
Summary: Corporate Market Risk Management is a Process

Define
Measure
Manage
Monitor
giddy.org
Ian Giddy
Ian H. Giddy NYU Stern School of Business 44 West 4th Street, New York, NY 10012 Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org
giddy.org

Financial Risk Management: Prof. Ian Giddy

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SIM/NYU The Job of the CFO

Financial Risk Management

Risk Management is a Process

Corporate Risk Management

Copyright 2001 Ian H. Giddy

Financial Risk Management -5

Financial Risk Management

Financial risk management must be tied to the companys business

Copyright 2001 Ian H. Giddy

Financial Risk Management -6

The Case For Hedging

Copyright 2001 Ian H. Giddy

Financial Risk Management -7

Optimal Capital Structure

HEDGING CAN REDUCE COSTS OF FINANCIAL DISTRESS

Copyright 2001 Ian H. Giddy

Financial Risk Management -8

Hedging, Valuation, Taxes and Financial Distress

Net worth of the firm

Copyright 2001 Ian H. Giddy

Financial Risk Management -9

When Should Firms Hedge?

Copyright 2001 Ian H. Giddy

Financial Risk Management -10

Which Firms Should Hedge?

And firms that have:

Financial Risk Management -11

What Exposure Should Firms Hedge?

exposure Economic exposure

Rate Risk Commodity Price Risk

Copyright 2001 Ian H. Giddy

Financial Risk Management -12

Measuring Market Exposure

A risk management framework

Copyright 2001 Ian H. Giddy

Financial Risk Management -13

How Effective is My Companys Risk Management? Warning Signs:

Copyright 2001 Ian H. Giddy

Formalize Risk Management Policy and Control Framework

Corporate Risk Management

Financial Risk Management -15

Identification and Definition of Financial Exposures

Copyright 2001 Ian H. Giddy

Financial Risk Management -16

Market Risks: Definitions

Three Views of Market Price Risk:

Sheet/Portfolio Economic risk.

Copyright 2001 Ian H. Giddy

Financial Risk Management -17

Market Risks: Definitions

Three Views of Market Price Risk:

Sheet/Portfolio Economic risk.

Copyright 2001 Ian H. Giddy

Financial Risk Management -18

Financial Risk Management -19

But Transactions Exposure Can be Misleading...

Copyright 2001 Ian H. Giddy

Financial Risk Management -20

Copyright 2001 Ian H. Giddy

Financial Risk Management -21

Interest Rate Risk: Portfolio

Financial Risk Management -22