Corporate Risk Management
Session 1-2
Introduction
Lecture Schedule
[Link] to Corporate Risk
Management
[Link] of Risk & Return
[Link], Probability & Basic Statistics for
Risk
7-8Modeling Volatility & Value at Risk
Lecture Schedule
9-10Interest Rate Markets
11-12Interest Rate Risk Management
13-14Foreign Exchange & Risk
Management
15-16Equity & Options Risk Management
17-18Risk Management in Financial
Institutions
Drivers of Risk Management
Sources of Corporate Financial
Risk
Interest Rate Risk
Foreign Exchange Risk
Managing Interest Rate Risks
• Understanding Interest Rate Markets
• Interest Rate Forwards & Futures
• Interest Rate Swaps
• Interest Rate Options & Futures
Managing Foreign Exchange
Risk
• Foreign Exchange Rate Markets & Mechanism
• Exchange Rate Forwards
• Exchange Rate Futures
• Currency Options
Financial Institution Risk
Management
• Credit & Operational Risk Management
• Credit Derivatives
• Basel norms for risk Management in
Banking
Enterprise Risk Management
• Risk Matrix, Risk Mapping, Risk Focus, Changing Face,
Risk and Business Strategy, Risk Assessment, COSO
Framework
• Implementing ERM – Strategic Issues, Defining RM
Policy, Roles and Responsibilities, RM Documentation,
Risk Architecture and Structure, RM technologies -
monitoring, evaluating, and improving the effectiveness
of risk management systems and processes; Integrated
Risk Management - global outlook, prospects and
challenges.
Definition of risk management
• The practice of defining the risk level a
firm desires, identifying the risk level it
currently has, and using derivatives or
other financial instruments to adjust the
actual risk level to the desired risk level.
Definition of Risk (Financial)
• The chance that an investment's actual
return will be different than expected. This
includes the possibility of losing some or
all of the original investment. It is usually
measured by calculating the standard
deviation of the historical returns or
average returns of a specific investment.
Definition of Risk
• A fundamental idea in finance is the
relationship between risk & return.
• The greater the amount of risk that an
investor is willing to take on, the greater
the potential return.
• The reason for this is that investors
need to be compensated for taking
on additional risk.
The Terminology
• Several Risks are defined in COSO
framework for Corporates :
[Link] Risk
[Link]
[Link]
[Link]
Corporate Financial Risk
• Accounting Standards
• Foreign Exchange
• Interest rates
• Credit & Funding Risk
Financial Risks are also defined
as
• Market Risks
• Price Risks
• Liquidity Risks
• Credit Risks
• Operational Risk
Market Risk
• The day-to-day potential for an investor or
organization to experience losses from
fluctuations in securities prices. This risk
cannot be diversified away.
• Also referred to as "systematic risk".
• The beta of a stock is a measure of how
much market risk a stock faces
Price Risk
• The risk that the value of a security or
portfolio of securities will decline in the
future.
• Basically, it's the risk the you will lose
money due to a fall in the market price of a
security that you own
Liquidity Risk
• The risk stemming from the lack of
marketability of an investment that cannot
be bought or sold quickly enough to
prevent or minimize a loss.
• Usually reflected in a wide bid-ask spread
or large price movements.
Credit Risk
• The possibility of a loss occurring due to
the failure to meet contractual debt
obligations.
• This is one of the measurements of the
likelihood that a party will default on a
financial agreement.
Operational Risk
• Operational risk is the risk of loss resulting from
inadequate or failed internal processes, people
and systems or from external events.
– Internal fraud
– External fraud
– Employment practices & workplace safety
– Clients, products & business practices
– Damage to physical assets
– Business disruption & system failures
– Execution, delivery & process management
Why Practice Risk Management?
• The Impetus for Risk Management
– Firms practice risk management for several
reasons:
• Interest rates, exchange rates and stock prices are
more volatile today than in the past.
• Significant losses incurred by firms around the
world that did not practice risk management
• Improvements in information technology
• Favorable regulatory environment
– Sometimes we call this activity financial risk
management.
Why Practice Risk Management
• The Benefits of Risk Management
– What are the benefits of risk management, in light of
the Modigliani-Miller principle that corporate financial
decisions provide no value because shareholders can
execute these transactions themselves?
• Firms can practice risk management more effectively.
• There may tax advantages from the progressive tax system.
• Risk management reduces bankruptcy costs.
• Managers are trying to reduce their own risk.
The perfect market assumptions
• No market frictions
– No transactions costs
– No taxes or government intervention
– No costs of financial distress
– No agency costs
• Equal access to market prices
– Perfect competition
– No barriers to entry
• Rational investors
– Return is good and risk is bad
• Equal access to costless information
Perfect financial markets
and corporate financial policy
• If financial markets are perfect, then
financial policy is irrelevant.
• If financial policy is to increase firm value,
then it must either increase the firm’s
expected future cash flows or decrease the
discount rate in a way that cannot be
replicated by individual investors.
T E CF t
V=
t =1 1+i t
t
Perfect financial markets
and risk hedging
• If financial markets are perfect, then corporate
hedging policy has no value.
• If corporate hedging policy is to increase firm
value, then it must either increase the firm’s
expected future cash flows or decrease the
discount rate in a way that cannot be replicated
by individual investors.
T E CF t
V=
t =1 1+i t t
When risk management matters
• Convexity in the tax schedule
– Progressive taxation
• Costs of financial distress
– Direct versus indirect costs
– Lost credibility (sales, expenses, etc.)
– Conflicts of interest between debt and equity
• Agency costs
– Conflicts of interest between managers and other
stakeholders
Progressive taxation
Taxes
15% tax rate 35% tax rate
Rs62,500
Rs37,500
Rs0 Rs250,000 Rs500,000
Taxable income
Progressive taxation
Unhedged tax liability
Tax = Rs0 Tax = 125,000
Rs0 Taxable income Rs 500,000
Expected taxable income = (½)(Rs0)+(½)(Rs500,000) = Rs250,000
Expected taxes = (½)(Rs0)+(½)(Rs125,000) = Rs62,500
Hedged tax liability Tax = 37,500
Rs250,000
Taxes = (.15)(Rs250,000) = Rs37,500
The value of tax incentives to
hedge
• Graham and Smith simulate the tax savings achieved
through hedging within the U.S. tax code.*
– A 5 percent reduction in the variability of taxable income results
in a 3 percent reduction in taxes for U.S. firms
– This is a savings of $142,360 for the typical NYSE/AMEX firm
– In some cases, tax savings from a 5 percent reduction in the
variability of taxable income approach 8 percent.
* John R. Graham and Clifford W. Smith, “Tax Incentives to Hedge,” Journal
of Finance 54, 1999.
Why Practice Risk Management?
(continued)
• The Benefits of Risk Management (continued)
– By protecting a firm’s cash flow, it increases the
likelihood that the firm will generate enough cash to
allow it to engage in profitable investments.
– Some firms use risk management as an excuse to
speculate.
– Some firms believe that there are arbitrage
opportunities in the financial markets.
– Note: The desire to lower risk is not a sufficient
reason to practice risk management.
Corporate Financial Risk
Management
Source: KPMG
Enterprise Risk Management History
Maturing as a business process
1950s-1960s 1970s 1980s 1990s 2004
Traditional Risk Risk management Companies Risk Release of
Management gains wider begin Risk management COSO ERM
(“TRM”) acceptance departments, matures as Integrated
typically companies begin Framework
focused on to focus on
insurance “business risk”
1950 1960 1970 1980 1990 2000
1977 Early 1985 1992 2002
Foreign 1980s National Committee of Sarbanes-Oxley
Corrupt Increased Commission Sponsoring Act of 2002
Practices focus on on Organizations
Act internal Fraudulent (“COSO”) 1990s-2000
(“FCPA”) control and Financial published Continued focus on
compliance Reporting — Internal internal control, risk
Treadway Control — management, and
Commission Integrated responsibilities
Framework (Blue Ribbon
Commission,
Competency
Enterprise Risk Management is intertwined with the Framework for
development of internal control standards and the Internal Audit,
regulatory environment. others)
Source: Deloitte & Touche LLP
Micro/Macro ERM
• Integrates risks Board • Regulatory
• Best practices Risk
• Balances Counsel / • Legal Risk
CRO CEO
perspectives Compliance • Governance
• Risk education • Audit
Chief Chief Head of Head of IT/
EVP Line Chief
Financial Investment Treasury/ Operations
Units Actuary
Officer Officer ALM
• Business • Financial • Market risks • Liability risks • Interest rate risks • Operational risks
risks risks - Fixed income - P&C - Parallel shifts - Processes
• Product risks • Capital - Equities - Life/Health - Curve twists - People
- Real estate - Commercial - Basis risks - Contingencies
• Customer • Statutory &
risks GAAP • Performance risks • Other issues • Other risks • Technology risks
Reporting - Tracking error - Expected - FX risks - Availability
Risk losses - Liquidity risks - Performance
- Alpha
- Unexpected - Security
• Rating - VaR losses
agency - Risk budget - Embedded
options
• Tax - Operational Risks
Source: James Lam, Enterprise Risk Management
Value at Risk (MNC)
Objective
To forecast the market risk of a hypothetical MNC financial assets using
the Value at Risk (VaR) methodology.
Company Methodology
Monte Carlo Simulation:
»Monte Carlo methods are a class of computational algorithms that
rely on repeated random sampling to compute their results.
»It is the most reliable method for VaR computation; however this
reliability depends on the number of the simulations applied.
Volatility Method: GARCH
»The best way to obtain dynamic volatility is to use methods that give
more weight on most recent values. These methods adjust the volatility
output in line with the shocks that might occur in the market.
»Our back-testing results support GARCH
FX exposure risk is the major factor of MNC Portfolio VaR.
» It can be stated that most of MNC Asset VaR is due to FX exposure.
» MNC Group have a significant amount of FX liability which lowers the
MNC Asset VaR.
Value at Risk
Reuters
- Market data from Reuters are fed
automatically (every evening) Analyzing before
investment decisions
Treasury
Front Office
VaR
System
Treasury
Reporting
VaR Results Middle VaR daily
- MNC Portfolio data from TMS are fed Office
automatically (every evening)
TMS Treasury
Reconciliation of accounts and
MNC ERP accounting treatments
Value at Risk (MNC)
– VaR Limit Structure for MNC Derivative Portfolio:
The Limit Structure will have three different limit levels;
» Green Level:
– Normal level that daily VaR of the Derivative Portfolio would not exceed.
» Yellow Level:
– Maximum temporary high level allowed if a shock in volatility occurs.
– If Yellow Level is exceeded, this would be reported to CFO.
» Red Level:
– Extreme limit that will not be exceeded.
– Corrective action will be taken (unwinding options etc.) once the Red Limit is exceeded.
Framework of ERM Can be
Summarized…
1) When credit ratings are used as the primary indicator of financial risk, the
firm determines an optimal or target rating based on its risk appetite and the
cost of reducing its probability of financial distress.
2) Given the firm’s target rating, management estimates the amount of capital
it requires to support the risk of its operations. In so doing, management
should consider the probability of default.
3) Management determines the optimal combination of capital and risk that is
expected to yield its target rating.
4) Top management decentralizes the risk-capital tradeoff with the help of a
capital allocation and performance evaluation system that motivates
managers throughout the organization to make investment and operating
decisions that optimize this tradeoff.
Implementing ERM
ERM is conceptually straightforward, its implementation is challenging.
Inventory of Risks
Identify all of the company’s major risks (market, credit, liquidity,
operational, reputational and strategic.
Find a consistent way to measure firm’s exposure to these risks (a
common approach that can be used to identify and quantify exposures.
Without such a method, exposure to the same risk could have different effects
on the performance evaluation and decision-making of different business units
and activities.
Companies must be able to aggregate common risks across all of
their businesses to analyze and manage them effectively.
Implementing ERM
Economic Value vs. Accounting Performance
Credit ratings are often not the most reliable estimates of a firm’s
probability of default.
In such cases, management should rely on its own economics-based
analysis, while making every effort to share its thinking with the
agencies.
Financial ratios to be used after determining main concern of risk
management (Shortfall in cashflow or earnings?)
Accounting Problem
Volatile accounting earnings: If a company uses derivatives to hedge an
economic exposure but fails to qualify for hedge accounting, the derivatives
hedge can reduce the volatility of firm value while at the same time
increasing the volatility of accounting earnings.