Risk Management

New risks, new challenges

Published: Oct 2010

An effective risk management policy is essential for treasurers looking to support business strategy while protecting the company from uncertainty in the financial markets. This Business Briefing looks at the key ingredients for a successful risk management policy.

In recent times, much has been written about the increasing importance of corporate treasury in the building and managing of successful businesses. Recent market volatility, an unstable economic environment and constantly changing economic forecasts have meant that most companies face higher earnings volatility, lower margins and tighter covenants than three years ago.

On the other hand, some corporates are presented with unique opportunities driven by very favourable movements in the financial markets. These challenges require companies to increase their efficiency at every level.

An important milestone in achieving this goal is formulating and implementing an effective risk management policy. For those companies which already have an established policy, this may be the time to re-examine the relevance and effectiveness of that policy in this new market paradigm. In this Business Briefing, we examine key elements of a strategic approach to financial risk management that will help treasurers to design and implement a risk management strategy which is well aligned with the business strategy and which provides adequate levels of protection from uncertainty in the financial markets, while controlling the costs.

Considering risk at every step of corporate decision-making

A company’s overall risk exposures depend, amongst other things, on its asset mix, capital structure and funding strategy. For example, reducing the volatility of revenues by diversifying the asset mix could allow the company to be more leveraged. This, in turn, would dictate a proper proportion of floating rate debt in the funding mix. Additionally, a company’s revenue mix will have an impact on the optimal currency composition of its liabilities.

Figure 1: A company’s overall risk exposures
Figure 1. A company’s overall risk exposures

Furthermore, the evolving nature of a business should be taken into account. What may not represent a significant exposure today could become a key risk factor five years from now. The complex relationship between financial and non-financial risks further increases the importance of aligning the risk management strategy with the business strategy.

Companies are also faced with the issue of absolute hedging vs. relative hedging. In particular, every company should balance its own risk tolerance with the risk appetite and hedging strategies of its close competitors. While it is important for companies to protect their own businesses from extreme adverse market movements, excessive hedging can become a competitive disadvantage in a favourable market environment.

Risk management strategy is the key element of success

To ensure that a company is adequately prepared for dealing with the uncertainty of the financial markets, a rigorous, yet flexible risk management strategy should be in place. Three major components of such a strategy are:

  • Evaluation of risk. Measure the company’s current risk exposure across different classes, taking into account that some of the risks enhance each other while others offset each other. At this stage a number of important questions need to be considered. In particular:
    • What role does business strategy play in establishing the risk management programme?
    • What is the total risk exposure?
    • How much does each risk factor add to the total risk exposure?
    • What are the natural diversification benefits of non-perfect correlations?
    • What move in each risk factor may cause a company to breach financial covenants?
  • Determining risk tolerance. Set the risk management targets based on the company’s risk tolerance, benefiting from the fact that total risk exposure is less than the sum of individual exposures. In the course of this exercise, the following points need to be considered:

    • How much financial market volatility can a company absorb before the performance targets are compromised?
    • What are the appropriate risk measures?
    • How should the risk tolerance thresholds be established?
  • Defining acceptable risk mitigation strategies and conditions for their implementation. Identify key ‘contributors’ to total risk, find optimal ways to mitigate them and choose the right instruments to implement the risk mitigation strategy. The focus should be on:

    • When to initiate or change the hedging program and how to optimise hedge ratios.
    • What is the relative value of different hedging strategies?
    • How to use the debt portfolio as a natural hedging instrument.
    • What are the ways to reduce the net income or asset volatility?
    • What is an optimal fixed/floating duration profile of the liability portfolio?
    • What is the impact of regulatory and accounting frameworks on risk management discussions?
    • What is the tactical corridor to implement strategic changes?
Figure 2: Components of a risk management strategy
Figure 2: Components of a risk management strategy
  • Analyse company’s business strategy and balance sheet and establish whether FX, interest rates, inflation, commodities can impact future earnings.
  • Use Monte Carlo methodology to simulate the various sources of uncertainty and future market dynamics.
  • Take into account historical and market implied relationships between all modelled market factors.
  • Identify appropriate risk metrics, eg worst case for interest expense, interest cover, net income, profit before tax.
  • Calculate company’s performance on each of the modelled paths.
  • Create a natural distribution for each risk of the identified metrics.
  • For each relevant risk metric, establish the levels which should not be breached.
  • Identify an individual contribution of each risk facet, taking into account its volatility, degree of exposure and diversifying impact.
  • Dimension the hedging exercise by comparing the current risk levels with established risk tolerance thresholds.
  • Taking into account hedging, market constraints, accounting and regulatory implications, identify the most efficient hedging strategy.
  • Considering tactical indicators, establish a timeline for executing the proposed hedging programme.

Choosing appropriate risk metrics

The definition of risk is individual for every company. There are two fundamental decisions a person focusing on risk management should make:

  • In what terms do the exposures have to be measured? In other words, should the company focus on net income, margins, free cash flows, interest coverage, interest expense, etc?
  • How much uncertainty is acceptable to the company around the chosen risk measure?

Sometimes it is necessary to run the risk management exercise on more than one parameter. For example, when hedging FX exposures, both cash flow hedging and net investment hedging are usually considered. When this complex approach is adopted, it is also important not to underestimate the impact of related risk factors.

To keep matters simple, some treasurers believe that measuring risk on the single parameter and single risk facet basis is more practical. However, the importance of risk diversification cannot be underestimated. While a single variable approach may make the risk analysis easier, it may lead to significant over-hedging which, in turn, leads to unnecessary cost and loss of opportunity.

Certain volatility can improve risk profile

The important parameter of risk tolerance is the amount of uncertainty that a company is willing to tolerate. Some treasurers prefer to manage their portfolios to the ‘minimum volatility targets’, in other words, to focus almost exclusively on the reduction of volatility of interest expense.

This approach can often create more cost than benefit. As can be seen from the graph below, if companies’ liabilities are completely hedged, the revenue volatility can cause the EBITDA coverage ratio to be breached. While the absolute level of interest expense remains the same, lower EBITDA will reduce the coverage ratio. Clearly a hedging strategy that would align top line movements with changes in interest expense could provide better protection in this case.

Figure 3: Hedging strategies
Figure 3: Hedging strategies

Source: Lloyds Banking Group Analytics

How to measure risk

It has become a standard practice to use the Value-At-Risk (VaR) approach to measure financial risks. In simple terms, VaR is very similar to volatility, or uncertainty, around the future value of a certain market factor or performance parameter. This approach to measuring risk, however, does not give proper credit to strategies that significantly improve expected outcome while introducing additional volatility.

Let us consider an example. We take a very simple debt portfolio which consists of one USD fixed rate bond issued today with the tenor of five years and paying 3.67% (reflecting a 1.67% five year swap rate and 2% credit spread). Over next five years this portfolio will not have any interest expense volatility – the bond will continue to pay 3.67%. Let us now assume that this bond is swapped into a floating rate. Generally speaking, this portfolio will now incur the interest expense of USD LIBOR + 2%, or around 2.29% if the current rates prevail.

If interest rate risk is measured as volatility, then our new, swapped, portfolio is clearly riskier. However, once the fact that the volatility of the swapped portfolio is centred around the lower number is taken into account, we may find that not only expected interest expense, but also ‘worst case’ interest expense of the new portfolio are better than those of the original fixed rate portfolio.

Another shortcoming of measuring risk as volatility should be mentioned here. As a measure of uncertainty, volatility is only informative for normal and log-normal distributions. Once the focus is turned into real life, uncertainties may not follow the rules of mathematical distributions and volatility measures can be deceitful. For example, for any so-called ‘fat tailed’ distribution, volatility measures would fail to capture the extent of the possible losses.

To address these concerns, more and more treasury professionals recognise the need to consider ‘worst case’ outcomes instead of volatility and at the same time turn their attention to those tools that allow the analysis of natural or so called ‘non-parametric’ distributions.

Measure in time

Once an appropriate risk metric is chosen and a measuring methodology is in place, it is important to follow the risk dynamic over time. A number of key risk factors change with time, impacting the total risk exposure. First of all, the markets move. Second, the balance sheet’s exposure to the market changes due to business volatility. This means that the risk exposures today are not the same as they will be in one year, two years, three years and so on. Moreover, the economic risk, that is to say the total impact over a period of time, may be very different from reporting risk or uncertainty experienced from one period to another.

The chart below demonstrates the evolution of a company’s interest cover ratio over time depending on the fixed/floating composition of the company’s debt portfolio. The blue lines correspond to the 100% fixed rate portfolio (expected and 95th percentile worst case). The red lines correspond to the 100% floating portfolio (expected and 95th percentile worst case). As the chart shows, what is not a concern today can easily become a critical risk factor three years from now. This analysis, prepared for a major UK corporate, became an integral part of the company’s risk management discussion.

Figure 4: Measuring economic risk
Figure 4: Measuring economic risk

Source: Lloyds Banking Group Analytics

Balancing economic and reporting risk is an important task. Whereas from the value creation perspective, a treasurer should focus on the overall economic impact the financial markets can have on the business, from the reporting stand point, period-to-period uncertainty needs to be managed. To find an appropriate trade-off between these two objectives, risk professionals turn to the ‘path dependent’ approach.

When risk is evaluated it is important not only to measure it, but also to gain an understanding of the market dynamics that would lead to the worst case performance outcomes. Interestingly, it is quite often the case that a perfect financial storm is caused by insignificant movements of individual market factors. For example, a UK-based industrial company could sustain a wide range of individual volatility in EUR/GBP, electricity cost and UK and European interest rates. However, if a number of these market variables move together a company will experience a noticeable impact on earnings.

As a part of the risk management exercise the risk factors should be modelled consistently, on the period-by-period basis. A risk manager can then study those paths that cause a company to breach its risk tolerance target. Gaining the insight into the ‘problematic’ paths is very useful for a number of reasons:

  1. The extent of the moves in each risk factor can be better appreciated.
  2. This approach can be utilised as an early warning mechanism to prepare for financial storms.
  3. The efficiency of hedging instruments can be evaluated under the stressed market conditions.

Don’t dismiss optionality

When evaluating the efficiency of hedging strategies, many risk professionals have to find a balance between the level of protection and the cost of hedging. This cost can come from premiums paid for protection or from the opportunity costs associated with buying certain instruments. In the very same way that we evaluate the insurance premium relative to the level of protection we obtain by purchasing an insurance policy, we should always compare what it will cost to achieve a desired level of protection in the financial markets.

There are times when opportunity costs are simply too high and paying an option premium (to gain protection without losing the opportunity) makes it more prudent. For example, when a yield curve is very steep and market implied volatility is relatively low, it may potentially be better to go with a capped floating solution rather than a fixed rate debt.

Choice of instruments – accounting friendly or not

When choosing hedging instruments, companies often limit their choice to those with favourable accounting treatment. These are selected mostly because they do not add any accounting volatility and are easier dealt with internally. However, in certain cases, instruments with embedded optionality provide very efficient protection. Under these circumstances it is important to evaluate the degree of net income volatility reduction which is achieved by these instruments, add back a possible mark-to-market volatility generated by the hedging instruments and then decide if there is a net benefit.

This calls for a higher degree of integration between the risk analytics and accounting evaluation of proposed risk management strategies.

Choose the right tools

As risk management gets more and more complex, access to a good set of tools becomes a key component for the successful design and implementation of a risk management programme. These tools should allow a treasurer to:

  • Measure current risk exposures.
  • Model relevant market factors on the period-by-period basis.
  • Stress test the relationships between relevant market factors.
  • Overlay the balance sheet and its evolution over the modelled market environment.
  • Choose the universe of hedging instruments.
  • Evaluate hedging strategies, taking into account:
    • Transaction costs.
    • Accounting implications.
  • Produce intuitive analysis which will allow for suggested strategies to be vetted and accepted internally.

Questioning assumptions, re-evaluating models and adapting conclusions form the basis of the risk manager’s inquisitive mind-set, which is essential to good risk management in a world of ever-changing financial risks.

Lloyds Banking Group

Lloyds Banking Group is a leading UK based financial services group providing a wide range of banking and financial services, primarily in the UK, to personal and corporate customers.

Lloyds Banking Group was formed in January 2009 following the acquisition of HBOS and our main business activities are retail, commercial and corporate banking, general insurance, and life, pensions and investment provision. The new Group also operates an international banking business with a global footprint in over 30 countries.

Our risk management offering includes a comprehensive range of cost effective risk management products and services across a wide range of global asset classes covering Foreign Exchange, Interest Rates, Inflation and Commodities.

For more information visit www.lloydstsb.com/corporatemarkets

Contact details:
Yuri Polyakov
Head of Risk Solutions
+44 (0)20 7158 3997
www.lloydstsb.com/corporatemarkets
Lloyds Banking Group

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