What is Risk Management Archives - Page 53 of 53 - treasuryXL

|31-1-2017 | Lionel Pavey |

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my first article of this series I wrote about risk managment and what the core criteria are for a solid risk management policy. Today I want to focus on interest rate risk. There are 4 types of interest rate risk.

Absolute Interest Rate Risk

Absolute interest rate risk occurs when we are exposed to directional changes in rates – either up or down. This is the main area of rate risk that gets monitored and analysed within a company as it is immediately visible and has a potential effect on profit.

Yield Curve Risk

Yield curve risk occurs from changes between short term rates and long term rates, together with changes in the spreads between the underlying periods. Under normal circumstances a yield curve would be upward sloping if viewed as a graph. The implication is that longer term rates are higher than short term rates because of the higher risk to the lender and less liquidity in the market for long dated transactions. Changes to the yield curve (steepening or flattening) can have an impact on decisions for investment and borrowings, leading to changes in profit.

Refunding or Reinvestment Risk

Refunding or reinvestment risk occurs when borrowings or investments mature at a time when interest rates are not favourable. Borrowings or investments are rolled over at rates that had not been forecast leading to a potential loss on projects or investments.

Embedded Options Risk

Embedded options are provisions in securities that cannot be traded separately from the security and grant rights to either the issuer or the holder that can introduce additional risk. Benefits for the issuer can include a call option, a right to repay before maturity without incurring a penalty, an interest rate cap. Benefits for the holder can include a put option, a conversion right via convertible bonds, an interest rate floor.

An attempt can be made to calculate the interest rate risk on either a complete portfolio or on individual borrowings or investment. This is done by comparing the stated interest rate to the actual or projected interest rate. Methods include:

Mark to market
Parallel shift in the whole yield curve
Tailor-made shift in the whole yield curve
Duration, DV01, Convexity
Value at Risk (VaR)

These are all forms of quantitative analysis and well recognized. Personally I am of the opinion that VaR is not a very good method for interest rates. Interest rates do not display normal Gaussian distribution – they do not resemble a normal bell curve. Interest rate distribution curves display fat tails compared to normal statistical models.

Financial products that are commonly used to manage interest rate risk include FRAs, Futures, Caps, Floors, Collars, Options, Interest Rate Swaps and Swaptions.

Lionel Pavey

Cash Management and Treasury Specialist

More articles from this author:

Safety of Payments

The treasurer and data

The impact of negative interest rates

How long can interest rates stay so low?

| 23-1-2017 | Lionel Pavey |

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk.
It is a negative event that can potentially lead to loss or liability; it is exposure to uncertainty; it is a deviation from the expected outcome. It can be caused by people, changes in the law, products used in day-to-day activity to facilitate the business. Risk is not an uncertainty – it is a “known unknown”

Risk arises in every activity of a company and, therefore, a procedure of risk assessment has to be determined within a company and controls implemented. We can conclude that a risk management policy is a crucial part of the risk management function. The policy provides a framework – and details the framework – for decision making, whilst adhering to the company’s agreed viewpoint on risk.

Risk Management

A risk management policy can be very extensive as it relates to all risks faced by a company – we shall only focus on the risk relating to treasury operations. Treasury risk policy should be developed by the Treasury department, together with management, and approved by the board of directors. Once approved and implemented, the policy should be regularly reviewed and amended to ensure that it effectively meets the changing risks as the company advances.

Core criteria

The core criteria for undertaking the policy include:

Providing a framework (matrix) for financial decision making
Defining a policy for identifying and controlling risk
Confirmation of the objectives and restrictions set by the board of directors and management
Safeguarding the interests of stakeholders
Enabling the reporting and measurement of treasury risk to the board of directors and management

Strategic components

Strategic components related to the policy include:

Objectives
Standards of care
Authority and Responsibility
Requirements for third party providers
Types of transactions
Constraints on transactions
Reporting
Policy review process
Benchmarking

Major treasury related risks that shall be discussed in my next articles include:

Interest rate risk
Foreign Exchange risk
Commodity risk
Credit risk
Operational risk
Liquidity risk

A search through Google will show more risks, but we are attempting to show and discuss the main types of risk in treasury operations.

In the rest of the series, we shall elaborate on the above 6 major treasury related risk categories.

“Risk comes from not knowing what you are doing” – Warren Buffett