Managing treasury risk: Credit Risk (Part V)

| 23-2-2017 | Lionel Pavey |

 

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my fifth article I will focus on credit risk. Many companies have very significant credit needs and this needs to be formally addressed with a credit analysis procedure in place. In my former articles I dealt with risk management, interest rate risk, foreign exchange risk and commodity risk. See the complete list at the end of today’s article.

Credit Risk

Credit Risk occurs when there is a risk of default from money that has been lent to a borrower, or funds that have been invested.
The risk can be caused by:

  • Trade credit extend to a client, who does not pay
  • Inability to make a payment on a loan
  • A company going bankrupt
  • An insurance company not paying under a policy
  • A bank becoming insolvent
  • A company not paying wages to employees
  • A government defaulting

Main categories

The main categories of credit risk are:

Default risk
Counterparty risk
Sovereign risk
Legal risk
Concentration risk

Default risk:
occurs due to the default on monies owed either from lending or investment. The counterparty could be unable to repay. Sometimes they could also be unwilling to repay. The default risk is therefore on 100% of the outstanding balance, unless some form of recovery (be it full or partial) was possible.

Counterparty risk:
occurs when counterparties have to perform an action on a contractual commitment.
This can happen at both the time of settlement and also before settlement, but after entering a contract. Since the start of the financial crisis settlement risk is a major factor for banks. If at settlement a counterparty fails to meet its obligation, this can potentially lead to large losses and, eventually, to a systemic risk as you are therefore unable to meet your own obligations. A default before settlement can be alleviated by substituting a new contract though this could occur at prices far less favourable.

Sovereign risk:
entails the political, legal and regulatory exposures arising from international trade and cross border transactions. It can relate to a government failing in its obligation to repay or to new laws that prohibit free movement of funds – exchange control. Any contracts entered into with nondomestic counterparties should be analysed for the embedded sovereign risks and potential political instability.

Legal risk:
can occur if the counterparty is not legally allowed to enter into certain trades – especially derivative trades. We see in the media stories of companies that have experienced difficulties with derivatives leading to losses and court cases are started to either enforce or negate the contract. Also special purpose vehicles are formed purely to enter into certain transactions like securitisation issues. These are companies with no staff, fixed abode, or assets other than the underlying collateral of the issue.

Concentration risk:
 arises from lack of diversification. Too many loans from 1 or 2 banks, too many products purchased from 1 or 2 suppliers, too much revenue generated by 1 or 2 customers. This risk is a bit of a paradox as many companies become successful through concentrating their resources in key niche areas, whilst having to diversify their underlying risk at the same time.

Measures

There are, of course, measures that can be undertaken to identify and minimize these potential losses.

The first approach is counterparty ratings. Certain criteria can be examined – credit rating agencies, examination of financial statements, good knowledge of the counterparty, political, geographical (are they situated next to a volcano?) and legal status.

Notional exposure reveals the full amount outstanding with a counterparty – all the money that could potentially be lost.

Aggregate exposure netts the exposure with a counterparty between monies to be received and monies to be paid.

Clear picture of the replacement costs – the costs involved to replace the existing transaction with a new counterparty.

Techniques of measurement

Measurement of credit risk requires quantitative techniques to measure and model the risks.  An example would be Basel III that places a regulatory framework on banks to ensure adequate capital ratios. Eventually the techniques being used will trickle down to commercial companies. This should result in the creation of risk tools that are more sophisticated and improvements of the techniques used to report and measure risk.

However, as the financial crisis has clearly shown, over-reliance on sophisticated computer models appeared to lead to false comfort with the results generated by the modelling systems. This was caused by underestimating the risks in new financial products and the great assumption that is always prevalent in economic theory – people behave rationally at all times! Any model is a snapshot of the world and can only contain a few variables that are perceived as critical. All others are discarded to ensure that the model can work quickly and efficiently.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

 

 

More articles of this series:

Managing treasury risk: Risk management

Managing treasury risk: Interest rate risk 

Managing treasury risk: Foreign exchange risk

Managing treasury risk: Commodity Risk

 

Managing treasury risk: Commodity Risk (Part IV)

| 14-2-2017 | Lionel Pavey |

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my fourth article I will write about commodity risk, what the strategies around commodities are and how to build a commodity risk framework. More information about my first three articles can be found at the end of today’s article.

Commodity Risk

Commodity risk occurs due to changes in price, quantity, quality and politics with regard to the underlying commodities. This can refer to both the commodity as a whole and an input component of a finished good. Commodity risk usually refers to the risk in a physical product, but also occurs in products like electricity. It can affect producers, suppliers and buyers.

Traditionally, commodity price risk was managed by the purchasing department. Here the emphasis was placed on the price – the lower the price, the better. But price is only one component of commodity risk. Price changes can either be observed directly in the commodity or indirectly when the commodity is an input in the finished product.
Availability, especially of energy, is crucial for any company to be able to undertake operations. Combining commodity risk over both Treasury and Purchasing allows these 2 departments to work closer and build a better understanding of the risks involved. It also allows for a comprehensive view of the whole supply chain within a company. A product like electricity is dependent on the input source of production – gas, petroleum, coal, wind, climate – as well as the price and supply of electricity itself.

There are many factors that can determine commodities prices – supply and demand, production capacity, storage, transport. As such it is not as easy to design the risk management model as it is for financial products.

 General strategies that can be implemented

  1. Acceptance
  2. Avoidance
  3. Contract hedging
  4. Correlated hedging

Acceptance
Acceptance would mean that the risk exposure would be unchanged. The company would then absorb all price increases and attempt to pass the increase on when selling the finished product.

Avoidance
Avoidance and/or minimizing means substituting or decreasing the use of certain input components.

Contract hedging
Contract hedging means using financial products related to the commodity, such as options and futures as well as swapping price agreements.

Correlated hedging
Correlated hedging means examining the exposure of a commodity – the price of crude oil is always quoted in USD – and taking a hedge in the USD as opposed to the crude oil itself. The 2 products are correlated to a certain extent, though not fully.

Commodity risk framework

Commodity price speculation – most contracts are settled by physical delivery – affects the market more than price speculation in currency markets.
To build a commodity risk framework, attention needs to given to the following:

  1. Identify the risks
  2. Measure the exposure
  3. Identify hedging products
  4. Examine the market
  5. Delegate the responsibility factors within the organization
  6. Involve management and the Board of Directors
  7. Perform analytics on identified positions
  8. Consider the accounting issues
  9. Create a team
  10. Are there system requirements needed

Problems can arise because of the following:

  1. Relevant information is dispersed throughout the company
  2. Management may not be aligned to the programme
  3. Quantifying exposure can be difficult
  4. There is no natural hedge for the exposure
  5. Design of reports and KPI’s can be complex

It requires an integrated commitment from diverse departments and management to understand and implement a robust, concise policy – but this should not be a hindrance to running the policy.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist 

 

 

More articles of this series:

Managing treasury risk: Risk management

Managing treasury risk: Interest rate risk 

Managing treasury risk: Foreign exchange risk

 

Managing Treasury Risk – Foreign Exchange Risk (Part III)

| 7-2-2017 | Lionel Pavey |

 

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my third article I will focus on foreign exchange risk. This risk has to be taken into consideration when a financial commitment is denominated in a currency other than the base currency of a company.
There are 4 types of foreign exchange risk.

Transaction Risk

Transaction risk occurs when future cash flows are denominated in other currencies. This refers to both payables and receivables.  Adverse changes in foreign exchange prices can lead to a fall in profit, or even a loss.

Translation Risk

Translation risk occurs when accounting translation for asset and liabilities in financial statements are reported. When consolidating from an operating currency into a reporting currency (overseas offices etc.) the value of assets, liabilities and profits are translated back to the reporting currency. Translation risk does not affect a company’s cash flows, but adverse changes can affect a company’s earnings and value.

Economic Risk

Economic risk occurs when changes in foreign exchange rates can leave a company at a disadvantage in comparison to competitors. This can affect competitive advantage and market share. Future cash flows from investments are also exposed to economic risk.

Contingent Risk

Contingent risk occurs when potential future work is expressed in a foreign currency. An example would be taking part in a tender for work in another country where the pricing is also in a foreign currency. If a company won a large foreign tender, which results in an immediate down payment being received, the value of that money would be subject to transaction risk. There is a timeframe between submitting a tender and knowing if the tender has been won, where a company has contingent exposure.

Identifying Foreign Exchange Risk

  1. What risk does a company face and how can it be measured
  2. What hedging or rate management policy should a company use
  3. What financial product, available in the market, should be best used
  4. Does the risk relate to operational cash flows or financial cash flows

Initially we need to ascertain what we think future FX rates will be. Methods that can be used include the Forward Rate Parity, the International Fisher Effect which also includes expected inflation, forecasts provider by banks and international forums, along with VaR. Model analysis can be provided, among others, via fundamental factors, technical analysis, and political analysis.

Different FX rates can then be used to simulate the effects on cash transactions when converted back into the base currency. This will provide different results that will allow a company to determine what level of risk it is prepared to accept. Finally a decision must be taken as to whether the company wishes to hedge its exposure or not. Before the advent of the Euro, both the Netherlands and Germany  were members of the Exchange Rate Mechanism (ERM). This meant there was agreed band within which the spot rate could move around an agreed central point – this was NLG 112.673 equal to DEM 100.00 with a bandwidth of +- 2.25%. For some companies, this tight band meant that they took the decision not to hedge any exposure between DEM and NLG.

Financial products that are commonly used to manage foreign exchange risk include Forward Exchange contracts, Futures, Caps, Floors, Collars, Options, Currency Swaps and Money Market hedging.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

 

More articles of this series:

Managing treasury risk: Risk management

Managing treasury risk: Interest rate risk 

Managing treasury risk: Interest rate risk (Part II)

|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:

  1. Mark to market
  2. Parallel shift in the whole yield curve
  3. Tailor-made shift in the whole yield curve
  4. Duration, DV01, Convexity
  5. 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

 

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?

 

Managing treasury risk : Risk Management (Part I)

| 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:

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

Strategic components

Strategic components related to the policy include:

  1. Objectives
  2. Standards of care
  3. Authority and Responsibility
  4. Requirements for third party providers
  5. Types of transactions
  6. Constraints on transactions
  7. Reporting
  8. Policy review process
  9. 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

Lionel Pavey

 

 

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?