Risk Management – what does it mean

| 24-5-2017 | Patrick Kunz |

You might visit this site, being a treasury professional with years of experience in the field. However you could also be a student or a businessman wanting to know more details on the subject, or a reader in general, eager to learn something new. The ‘Treasury for non-treasurers’ series is for readers who want to understand what treasury is all about.
Our expert Patrick Kunz tells us more about an important task of a treasurer: Risk Management

Background

One of the main task of a treasury is risk management, more specifically financial risk management. This is still broad as financial risk can result from many origins. Treasury is often involved in the risk management of Foreign currency (FX), interest rates, commodity prices and sometimes also balance sheet/profit loss. Furthermore insurances are often also the task of the treasurer.

Exposure

To be able to know how to reduce a certain risk the treasurer first needs to know about the risk. Often risk positions are taken outside of the treasury department. The treasurer needs to be informed about these risk positions. FX and commodity price exposure is often created in sales or procurement while the interest rate risk is created in the treasury department itself (although this is not always the case). In an ideal world the treasurer would like to know an exposure right after it is created. Often IT solutions or ERP connections with treasury help with that.

Policy

Once the exposure is know the treasurer needs to decide whether it is a risk position or not and whether he wants to mitigate this risk by hedging it. Let me explain this with an FX example: A EUR company who buys goods in USD is at risk for movements in the EUR/USD rate. However, if the company is able to sell these goods at the same time they are bought (a sales organization), for  USD then the net exposure could be lower. Risk Exposure is therefore lower as only the profit needs to be hedged.

Risk appetite of the company determines if the treasurer needs to take action on certain risk exposure. Some companies hedge all their FX exposure. The reason for this is often because FX risk is not their core business and therefore not a business risk. Non-core risk needs to be eliminated. Commodity risk is sometimes not hedged as this is the company’s core business or a natural hedge as the companies is also producer/miner and seller of the commodity. Other companies have more risk appetite and hedge only amounts above a certain threshold. Due to internal information restrictions, delays or accounting issues and the fact that some currencies are not hedgable most multinationals always have some FX exposure. In the profit and loss statements you often see profit or losses from FX effect, either realized or non-realized (paper losses).

Hedging

Once you know the risk position the treasurer needs to determine how to reduce the risk of that position. He does that by hedging a position. A hedge is basically taking an opposite position from the risk. Preferably the correlation of these positions is -1 which means that both positions exactly move in opposite directions, thereby reducing the risk (ideally to 0). For FX the treasurer can sell the foreign currency against the home currency on the date the foreign currency is expected, either in spot (immediate settlement) or forward (in the future), removing the FX exposure into a know home currency exposure.

Certain vs uncertain flows

Important about hedging is the way you hedge. A hedge can commit you to something in the future or a hedge can be an optional settlement. This should be matched with the exposure. If the exposure is fully certain then you should use a hedge which is fully certain. If an exposure is only likely to happen (due to uncertainty) then you should use a hedge that is also optional.

Example1: a company has a 1 year contract with a steel company to buy 1000MT of steel every month at the current steel price every month. The goods need to be bought under the contract and cannot be cancelled. This company is at risk for the steel price every month because the steel price changes every day. The treasurer can hedge this with 12 future contracts (1 for every month) locking in the price of the steel for 1000MT. The future contract also needs to be settled every month matching the risk position. 0 risk is the result.

Example2: company X is a EUR company and looking to take over company Y, a USD company. The company needs to be bought for USD 100 mio. Company X has the countervalue of this amount in cash in EUR. The companies are still negotiating on the deal. Currently the EUR/USD is at 1,10. The deal is expected to settle in 6 months. Company X is at risk for a change in the EUR/USD rate. If the deal goes through and the rate in 6 months changes negatively then X needs more EUR to buy USD 100 mio. making the deal more expensive/less attractive. There is a need to hedge this. If this would be hedged with a 6M EURUSD forward deal the FX risk would be eliminated but there is still the risk that the deal is cancelled. Then X has the obligation out of the hedge to buy USD 100 mio. which they have no use for. This is not a good hedge. A better hedge would be to buy an option to buy USD 100 mln against EUR in 6 months. This instrument also locks in the EURUSD exchange but with this instrument the company has the option to NOT use the hedge (if the deal is cancelled) matching it ideally with the underlying deal.

Conclusion

For a treasurer to do effective risk management he needs information from the business to determine the risk exposure. Furthermore he needs to assess the certainty of this exposure; how likely is the exposure to happen. With this information, together with the pre-determined risk appetite (whether or not written down in a policy confirmed by senior management), the treasurer can decide if and how to hedge the position. The certainty of the exposure determines the hedging product that is used.

Hedging products can be complex. Banks can structure all kinds of complex derivatives as hedging products. It is the task of the treasurer to determine the effectiveness of a hedge; a treasurer if often expert in these product and their workings. Hedging could have impact on accounting and sometimes profit/loss consequences but that is beyond the scope of this article.

 

 

Patrick Kunz

Treasury, Finance & Risk Consultant/ Owner Pecunia Treasury & Finance BV

 

Managing treasury risk: Operational Risk (Part VII)

| 21-3-2017 | Lionel Pavey |

 

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my last article on how to manage treasury risk I will write something about operational risk. The Bank for International Settlements (BIS) defines this as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.  If you want to read my earlier articles on managing the different treasury risks please refer to the complete list at the end of today’s article.

 

Whilst this is the last article in this series, it is actually – potentially – the most significant risk that a company can face, as there are many different ways that a loss could occur, together with the fact that when it happens the amount lost can be very large. Even if the size of the loss could be considered small, there is always the threat of reputation risk which, once identified, is very difficult to erase from the memory.

While it is possible to insure against rogue trading for a company (the risk present in the Treasury function can be quantified and qualified) it is very rare that damage is caused by just one individual – a financial version of the lone wolf theory. Operational risks tend to be interlinked – a fraudulent payment could be initiated by human involvement (either as fraud or human error) and facilitated by weak processes together with insecure technological systems.

There are 2 main areas of operational risk within treasury for a company

  1. Internal
  2. External

There are 3 main categories of operational risk within treasury for a company:

  1. Computer System, Information Technology
  2. Theft and Fraud
  3. Unauthorised Activity

Computer System, Information Technology

A lack of robustness and deficiencies in the technology and systems contribute to circumstances for failures, errors, data losses, corruption and fraud. Internally considerable care and attention should be given to the protocol for Static Data. This encompasses all the relevant reference data for a counterparty and should be subject to at least an input and verification procedure before entering the computer system. Changes to Static Data have to be recorded, together with the proper paper trail and authorization matrix. Externally the risks relate mainly to illegal entry (hacking), together with the complete theft of data.

Theft and Fraud

Both internally and externally main areas include:

  • Theft – both physical and electronic
  • Extortion
  • Embezzlement
  • Forgery
  • Misappropriation
  • Willful destruction
  • Bribes
  • Kickbacks
  • Insider Trading

Unauthorised Activity

From the Treasury point of view, this is an internal activity and mainly relates to 2 types of transactions – unauthorized by transaction and or type; transactions that are not captured in the system and reported. These can lead to monetary losses (though a gain is possible – at the price of an operational risk), together with loss of reputation.
The last category clearly shows where the biggest risk occurs within a company – at the human level. Generally speaking, these are caused by incompetence, lack of knowledge, misuse of power or compulsion to act caused by external factors – extortion.
It is clear therefore that whilst the electronic systems employed by a company can be a liability if not properly programmed or safeguarded, even here, most of the errors can be traced by to human intervention.

So why are the human risks so often underestimated? Naturally a company wishes to have the feeling that its staff can be trusted (within reason). After all, the company felt that the staff were the right people to employ. It is not my intention to formulate the reasoning and thinking of people who perform illegal acts. However certain areas that can be considered include how staff are treated; the demand placed on them; the rewards given; the levels of transparency and inequity within the company; a closed-off attitude (problems in one department are kept within that department and not discussed throughout the company); the role model set by owners, directors and managers; loss of personnel, reduction in morale; disinterested and unmotivated staff.

 Solutions

An effective framework of operational risk management needs to be designed and implemented within the business. This requires input and commitment from all departments within the company, meeting one agreed standard and not being shaped to every individual department’s wishes. The framework has to run and meet the requirements for all different strategies within the company.

I wish to finish with 2 examples of operational risk to illustrate how large they can be.

In 1995 the world’s second oldest merchant bank (Barings Bank) collapsed due to the actions of a rogue trader. Corruption and a lack of internal control led to a loss of GBP 827 million.

Around the same time I was employed as an international money broker working in the interbank market and travelled every day from The Hague to Amsterdam via train. As I knew the route off by heart, I read all the time – magazines, papers, books – anything. I purchased a book called “The Cuckoo’s Egg” as it seemed interesting and would pass the time away sitting on the train.
The synopsis told me that an unreconciled accounting discrepancy of just 75 cents would lead to a world of computer espionage and spies. I highly recommend reading the book to understand how a simple error can grow to show the dangers of ignoring operational risks. If you like acronyms then you will enjoy reading about the FBI, CIA, NSA and KGB – all hacked via a UNIX server at a laboratory linked to the University of California.The story is true and threatened national security.

Trust people – but do not place temptation in their way.

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: Credit Risk

Managing treasury risk: Liquidity risk

Managing treasury risk: Liquidity Risk (VI)

|13-3-2017 | Lionel Pavey |

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In today’s article I will focus on liquidity 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, commodity risk and credit risk. See the complete list at the end of today’s article.

Liquidity risk comes in 2 distinct forms – market liquidity risk and funding liquidity risk.

Market Liquidity Risk

This relates to assets and potential illiquidity in the market and, as such, can be considered a market risk. In a normal functioning market it is always possible for market participants (buyers, sellers, market makers and speculators) to find each other and negotiate a price for their transactions. Assuming that the transaction is of a normal market size, there should be no dramatic change to the price of the asset after the transaction.

At the time of a crisis, participants could be absent from the market, making it difficult – if not impossible – to trade an asset. Sellers are left frustrated as there are no opportunities to sell the asset they are holding and vice versa for buyers. This can occur due to a financial crisis, changes in legislature, scarcity of an asset or someone attempting to corner the market. An asset generally will have a value, but if there are no buyers in the market that value can not be realised.

Liquidity risk is not the same as falling prices – after all prices are free to rise or fall. If an asset was priced at zero then it means that the market considers its value to be nothing. This is different from trying to sell an asset but not being able to find a buyer.

Markets for Foreign Exchange, Stocks, Shares, Bonds and many Futures and other derivatives are generally highly liquid. Off balance sheet products related to physical settlement can be less liquid as there is a need to actually provide physical settlement. Bespoke products like CDO’s can be considered illiquid as their size is normally small (relatively speaking) and not freely tradeable. Also the complexity needed to value the product affects its liquidity.

Housing is an asset class with very low liquidity – sometimes a property could be sold as soon as it hits the market. At other times the same property could be available for sale for many years and the price reduced regularly, without attracting a firm buyer.
The easiest and quickest way to see if there is a heightened market liquidity risk is via the bid – offer spread. If this is suddenly seen widening, this would imply that there appears to be more risk. In a normal, liquid market, the spreads are fairly constant and small, allowing participants to easily step in and transact. A widening of spreads occurs in a normal market when government data is published – nonfarm payrolls, balance of payment, etc. Within a short time the market will return to a normal spread as the information is properly digested and the market makers return. However, if the spreads widen without a publication event taking place, it is reasonable to assume that the risk has increased.
Additionally, risk could grow if reserve requirements were increased. In markets such as Futures, it is necessary to pay margin to the exchange. If these margin payments were increased, this would lead to transactions being more expensive and so lead to less liquidity in the market.

Market makers can also observe the market depth. This is shown by the quantity available for transacting at a particular price in their order books. When a market is perceived as being deep, it means there are many orders and, therefore, a large number of orders would be needed to move the market price significantly. The deeper the market, the more liquid the market.

Funding Liquidity Risk

This relates to the risk of not being able to settle debts when they are due. Treasury specialists in a corporate environment are acutely concerned with funding risk. Every month wages must be paid, together with tax and social premiums (pensions, insurance etc.) Additionally, it would be advantageous to pay trade creditors on time. Future liabilities also have to be funded after they have been recognized. This could mean arranging external financing.

If there is a liquidity crisis in the market, it becomes difficult and expensive to arrange to borrow the necessary funds. The price may be so high that the intended profit provided by selling the goods, is negated by the increased cost of funding. A reduction in the credit rating of a company can also lead to increased costs and a reluctance to lend.
If a company is known to have problems making payments, then the liquidity risk is specific to the company – the rest of the market will function normally.

Funding risk can also occur if creditors fail to pay you, or if an unforeseen event has occurred that leads to an outflow of cash from the company.
A company can initially perform a quick spot check to ascertain its current ratio. This shows if a company can meet its current liabilities with its current assets. A ratio of less than 1 would imply that the company can not meet all its obligations at the same time. However, this could also be because there is no short term finance arranged at that moment.
It is possible to arrange a line of credit with a financial provider. He defines a maximum loan (line of credit) that can be extended which the company may utilize. While it is normal to pay a standing charge for the balance of the line that is not being used, this can be offset by the knowledge that it is possible to drawdown against the line when needed (in normal circumstances). There is greater flexibility with a line of credit than with a traditional bank loan.

Other methods include –

i)                    Sell assets like stock that are slow moving and tying down cash

ii)                   Analyse all overheads – office equipment, expense claims

iii)                 Increase efficiency in the debtors’ administration. Be proactive

iv)                 Renegotiate with suppliers – better that you talk to them before it is too late

v)                  Design contingency plans

vi)                 Subject your business to stress testing

vii)               Apply the techniques of ALM (asset and liability management)

 

Some very well known companies have fallen to liquidity problems – Bear Sterns, Lehman Brothers, Northern Rock, ABN Amro, AIG, etc. While the risks were prevalent before the crises, the main liquidity problems occurred when it was determined that there was no more time allowed for the situation to remain.
Time is the soul of business.

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: Credit Risk

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?