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Corporate Risk Management Strategies

The document discusses the importance of corporate risk management in a volatile and uncertain world, highlighting key steps such as risk identification, measurement, integration, response strategy development, and establishing a risk management framework. It emphasizes the evolution of risk management practices, particularly the shift towards integrated risk management systems and the use of financial derivatives as risk mitigation tools. Additionally, it outlines various risk types and the principle of comparative advantage in deciding whether to retain or transfer risks.

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0% found this document useful (0 votes)

13 views44 pages

Corporate Risk Management Strategies

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Strategic Financial Management:

Managing for Shareholder Value

Professor Prasanna Chandra
Week 4

Introduction to Risk Management

Welcome to session Corporate Risk Management. This session is based on the book Strategic
Financial Management Managing for Value Creation published by McGraw Hill. The outline
of the session is given here. Introduction, key steps in risk management, risk measurement, risk
mitigation measures, risk transfer mechanisms, management of forex exposure, management
of strategic and other risks, guidelines for risk management and behavioral aspects, risk
management practices.

We live in a VUCA world, volatile, uncertain, complex, and ambiguous. Thanks to rapid
globalization, interdependence of financial markets, shifts in economic power, and pressure on
natural resources, we are witnessing swings in currencies, raw material costs, equity prices,
and climate change. In early 20th century, Frank Knight, an eminent American economist,
wrote a seminal book titled Risk, Uncertainty, and Profit.

In this book, he made an important distinction between risk and uncertainty. He defined risk as
a situation where possible outcomes are known and probabilities can be assigned to these
problems outcomes. Uncertainty, on the other hand, refers to a situation where possible
outcomes are not known, let alone the probabilities associated with these outcomes, which
seem to be moving toward a world of more and more uncertainty.

The major forces creating uncertainty in the new economy are technology and the internet,
increased worldwide competition, free trade, and investment worldwide, Complex financial
instruments, notably derivatives, deregulation of key industries, changes in organization
structures resulting from downsizing, re-engineering and mergers, higher expectations for
goods and services, more and larger mergers.

Business firms are exposed to a variety of risks, technological risks, economic risks, financial
risks, performance risks, legal and regulatory risks, people risk, geophysical risk, and
environmental risk. The thrust of our discussion will be mainly on financial risk. We will look
at other risks as well.

© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any logo,
data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 4

In 1960s, Franco Modigliani and Merton Miller advanced a value conservation principle.
According to this principle, the value of a firm was not affected by its capital structure or
dividend policy or risk management policy. The view was that what a firm can do in these
areas, investors could replicate in the capital markets, so the firm need not do anything in this
area.

In 1970s, when the Bretton Woods Agreement was abandoned and opaque. Oil crisis emerged.
Financial prices became extremely volatile. Currency rates became volatile. Commodity prices
became volatile. Inflation became volatile. This had a hugely detrimental effect on a number
of corporates which were totally unprepared for such heightened volatility. The initial reaction
of these corporates was to forecast these financial prices.

Forecasters, however, in general, fail because financial prices tend to behave in a somewhat
random manner. In order to address the concerns of business firms, the financial services
industry, promoted derivative products such as forwards, futures, swaps, and options as a
solution to the risk management needs of corporates.

In 1980s, the academia also realized the importance of risk management and its contribution to
value creation. It was recognized that the total risk of a firm mattered because if a firm was
highly risky, it could cause adverse incentives for managers and diminish commitments of
various stakeholders. Also, it could lead to higher tax payment overall over a period of time.
The emergence of derivatives triggered the golden era of finance.

In 1990s saw heightened risk and highlighted the importance of systematic risk management.
And many organizations now have a position called chief risk officer and progressive risk
manager. Firms have enterprise risk management systems or integrated risk management
systems.

2000 saw the global financial crisis which many consider as a black swan. Nassim Taleb is a
leading risk philosopher of our times. He wrote a fascinating book called The Black Swan.
According to him, a black swan is a highly unlikely event which has a huge impact and for
which a very plausible story is concocted after the event has occurred.

Even the COVID crisis of 2020s is considered as a major black swan. Financial innovations
accelerated since 1990s. The motive force behind innovations like options, swaps, futures, and
their innumerable permutations and combinations came from demand and supply side. On the
demand side, floating exchange rates led to exchange rate volatility.

Likewise, interest rates became highly volatile in 1980. So corporates look for products which
help them in mitigating risk. On the supply side, as traditional sources of income for banks
such as interest, commissions, fees and so on were subjected to a squeeze, they started offering
complex, innovative products.

In the wake of these developments, the risk management perspective in progressive companies
is shifting from a fragmented ad hoc and narrow approach to an integrated continuous and
broad approach referred to as integrated or corporate or enterprise risk management.

Key Steps in Risk Management

Hello Learners, and welcome back. The key steps involved in systematic approach to risk
management are
1. Identify risks
2. Measure Risk,
3. Integrate Risks,
4. Develop a risk response strategy,
5. Institute risk infrastructure.

Identify risks: For example, TCS recognized risks as follows,

1. Strategic,
2. Operational,
3. Financial,
4. Compliance related.
In an article published in CFO magazine, Scott Lange, head of Microsoft Risk, identified 12
major sources of risk. Business partners, competition, customers, distribution, financial,
operations, people, political, regulatory and legislative, reputation, strategic, and technological.

The launch goal for Microsoft is to have risk management permeate the thinking of all
managers and employees of Microsoft and become an integral part of their job. In many ways,
it is similar to the quality movement of the 1980s and 1990s, which sought to take the
responsibility of quality out of a separate quality control department and make all managers
and employees accountable for quality.

After identifying risk, the next step is to Measure Risk.

At its simplest, measurement involves simply ranking various risks. At the next level, it
involves imputi;ng a monetary value to these risks. At a still higher level, it entails assigning
probabilities to them as well.

Integrate risks:Ideally, a company should integrate risk and adopt an enterprise wide approach
to risk management. Many companies, however, continue to manage risk in a piecemeal
manner. This is because professions are generally organized around a single skill set.

Develop a risk response strategy:A company can choose to mitigate risk, transfer risk, or
accept risk. A company's risk appetite, or that of its shareholders, determines its risk response
strategy. A company can mitigate its risk by making changes in its operations or its financial
structure. A company can transfer risk through following means, insurance, forwards, or future
swaps and options.

Institute risk management framework: Given the importance of risk management, firms are
now articulating In great detail, the Risk Management Framework.
This is the Risk Management Framework of Infosys, as drawn from one of its annual reports.
In this framework, there are three elements, Risk Categories, Risk Governance Structure, and
Key Risk Management Processes. Risk Categories spelt out as Strategy, Industry,
Counterparty, Resources, Operations, Regulations, and Compliance, Key risk management
processes are risk identification, assessment, risk measurement, mitigation, monitoring, risk
reporting and disclosure, integration with strategy and business plans. Risk governance
structure indicates the people involved in risk management. It starts with the InfoCN, Unit
Heads, Office of Risk Management, Risk Council, Risk Management Committee, Board of
Directors.

The two most important measures of risk are value at risk or VAR and cash flow at risk or
CFAR. Value at risk reflects a limit on the loss of value of a portfolio on account of normal
market movements, which will be exceeded only by a small pre specified probability. Thus, if
VAR is rupees 100 million or whatever with a confidence level of 95%, it means that there is
only a 5 percent probability the loss in portfolio will exceed rupees 100 million.

Zth quantile of a distribution is the probability that the random variable will be below that
number is Z percent and the probability that the random variable will be above that number is
100 minus Z percent. While Z can be 1, 2, 5 or any other number. We will use Z percent as
5%. If the return on a portfolio is normally distributed, VAR can be easily computed.

If X is a normally distributed random variable, U, which is defined as X minus expected value

of X divided by standard deviation of X follows a standard normal distribution. This means
expected value is 0 and standard deviation is 1. The VAR at a confidence level of 95 percent
represents the limit on loss that will be exceeded only 5 percent of the times at the end of a
given measurement period.
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any logo,
data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 4

As we have assumed, X is normally distributed, hence the 5th quantile of the distribution of X
can be obtained from the 5th quantile of U, and the 5th quantile of U is minus 1.65, which
means for a standard normal distribution, probability of values following below minus 1.65 is
5%. Hence, the 5th quantile of X is minus 1.65 times sigma x plus expected value of x. To
illustrate, suppose a bank has a portfolio of traded assets which have an expected return of 0.2
percent and a standard deviation of 6 percent on a weekly basis. The fifth quantile of the return
distribution is minus 1.65 times the standard deviation plus expected return which is 0.2
percent. This is minus 9.7 percent. For VAR, we consider the absolute value of the fifth quantile
or 9.7 percent. Hence, if the bank's portfolio is worth Rs. 100 billion, VAR is 9. 7 percent of
Rs. 100 million. or rupees 9.7 billion this means the probability of loss exceeding 9. 7 billion
is only five percent sum up our discussion war war reflects the limit on the loss of value of a
portfolio which will be exceeded only with a small pre specified probability The three steps
involved in calculating VAR are one define the time period, define the confidence interval,
calculate VAR.

In our example, we have used a time period or measurement period of one week. We have
defined the confidence interval as 95 percent. The expected return per week is 0. 2 percent. The
standard deviation of return per week is six percent. So the fifth question is Quantile of return
distribution is minus 1.65 multiplied by 6 percent which is standard deviation plus 0. 2 percent
which is expected return per week. This works out to minus 9. 7%. We work with an absolute
figure of 9. 7%. If the portfolio has a value of 100 billion limit on loss is 9. 7 percent of 100
million which is rupees 9.7 billion which means on a weekly basis the loss is not likely to
exceed 9.7 billion with a probability of more than five percent though widely used War suffers
from several limitations. One, it requires large amounts of historical data to assess expected
value and standard deviation. Two, it reflects the level of loss that will be exceeded with X
percent probability, but not the largest loss that can occur.

Companies use a number of operational measures for mitigating risk. The important ones are
listed here. Invest in stages, Improve information, shorten time to market, follow a suitable
pricing strategy, develop contingency plans, make long term arrangements, enter into strategic
alliance, build greater flexibility in operations, outsource, diversify.
Risk can be mitigated by making following changes in financial structure, reducing debt equity
ratio, carrying surplus liquidity.

Principle of comparative advantage in deciding whether a firm should retain or transfer risk. It
should follow the principle of comparative advantage A company may have no special ability
in forecasting market variables such as exchange rates interest rates for commodity prices So
it would do well to transfer these risks on the other hand.

It is likely to have a comparative advantage in bearing firm specific business risk. For example,
an R& D intensive pharmaceutical company like Amgen may have comparative advantage in
bearing R&D risks. The principle of comparative advantage reinforces the notion that
companies are in the business to take strategic and business risks.

It makes sense for companies to reduce non-core exposures. So, that they can take more
strategic business risk and exploit the opportunities in their core business.

Risk Transfer Mechanisms

Hello, learners, and welcome back.

Most common risk transfer mechanisms are forwards, futures, swaps, and options.

Forward contracts are perhaps the oldest and simplest tools for managing financial risk. A
forward contract represents an agreement between two parties to exchange an asset for cash at
a predetermined future [Link] called the settlement date for a price that is specified today.
For example, if you agree on January 1, to buy a hundred base of cotton on July 1 at a price of
Rupees 800 per bale from a cotton dealer, you have entered into a forward contract with a
cotton dealer. As per this contract on July 1, you'll have to pay rupees 80,000 and the cotton
dealer will have to supply 100 bales.

In forward contracts, it is common to think in terms of a short position and a long position. A
short position commits the seller to deliver an item at a contracted price on maturity. A long
position commits the buyer to to purchase an item at a contracted price on maturity. The
forward buyer is obliged to purchase the underlying instrument at the contract price or enter
into an offsetting transaction.

Let us look at the payoff profiles of a forward contract. Mr. X agrees to buy from Mr. Y. Some
share for rupees hundred to be delivered three months later. There is a forward contract between
X and Y. X is the forward buyer and Y is the forward seller. The contract price is C. The payoff
profile for the forward buyer, that is Mr.X is shown by this line. The contract price is indicated
by the intersection here. The contract price is hundred rupees if the Price of the share happens
to be 123 months later. Then the gain of XXI 20, if the price happens to be 80, the loss of XXI
20. As far as why the forward seller is concerned, the PR profile is shown in this graph, you'll
find that this profile is the mirror image of this [Link] X gains, Y loses. When X loses,
Y gains. To understand how a forward contract may be used for hedging, let us look at the case
of a refinery.

The inherent risk profile of the refinery with respect to the price of crude oil is shown here. If
the price of crude oil goes up, the refinery loses. If the price of crude oil falls, the refinery
gains.

In order to hedge this risk, the refinery enters into a forward contract to buy at a contract price.
The payoff of the forward contract, as we have seen, is like this. This payoff offsets the inherent
risk profile. So when the refinery buys a forward contract, it ensures that the inherent risk
profile is countered and its final payoff is given by this straight line.

There are several differences between forward contracts and futures contracts. Forward
contracts are traded over the counter. Futures contracts are traded on an organized exchange.
There is no secondary market for forward contracts. There is an active secondary market for
futures contracts. Forward contracts are contracts negotiated bilaterally between the buyer and
the seller and the terms are customized.

Futures contracts are standardized contracts in terms of quantity, date, and delivery conditions.
Most forward contracts end with physical delivery. Normally futures contracts are offset by a
counter transaction. There is no delivery. Forward contracts entail counterparty risk. There is
no counterparty risk as far as futures contracts are concerned because a clearing corporation
interposes itself between the buyer and the seller.

No collateral is usually required in a forward contract. In a futures contract, collateral has to be

posted with the exchange. Further, the contract is marked to the market on a daily basis.
Participation is limited to a small number of large traders as far as forward contracts are
concerned. A large number of participants participate in futures contracts.

Marking to market a futures contract may be likened to a series of forward contracts in

which each day previous day's contract is settled and that day's contract is written. To
understand how marking to market works, let us look at an example. A purchases a futures
contract on January 1 to buy one barrel of oil for 48 to be delivered on 31st January.

This is the futures price. Of that 31st January contract, so he agrees to buy at $48 on January
two. The same contract is priced lower at $47, which means he has lost $1. He pays that $1 to
the exchange. Essentially, he closed the previous contract and enters into a new contract under
which he agrees to buy one barrel of oil to be delivered on January 31 for $47.

On January 3, the same contract is priced higher at $49, which means A gains. What he has
agreed to buy at $47 is now selling at $49. So he gets a difference of 2 from the exchange,
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any logo,
data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 4

which means the previous contract is closed and he enters into a new contract to buy at $49.
There's no change in the price of the futures contract for the rest of the month.

So on January 31, a finally pays $49 and gets one barrel of oil. If you look at this arrangement,
you find that it has three important features. Both the buyer and the seller of a future contract
have to post a margin with the exchange. There is marking to market on a daily basis for the
buyer as well as the seller.

The exchange interposes itself between the buyer and the seller, so there is no counterparty risk
whatsoever. Just a way forward contract eliminates price risk. A futures contract eliminates
price risk. If there's the inherent risk profile of a company, it can enter into a futures contract,
which is a payoff like this. So the inherent risk profile is counter by the payoff of the future's
contract, and the firm is protected against price fluctuations.

Futures contracts have a tremendous appeal because of certain advantages.

1. There is no need for an initial cash flow. Accept the margin.
2. It is easy to go short as well as long.
3. It is easy to close a futures contract by an offsetting trade.
4. A wide range of futures contracts is available.

What is the relationship between spot and futures prices? We look at financial instruments first,
and then we'll examine commodity. In the case of a financial instrument, the futures price is
payable at some point of time in future.

On the left hand side, I have the discounted value of the futures price. So this represents the
present value of the futures contract. On the right hand side, I have the present value under the
spot contract. Under the spot contract. Spot price has to be paid today. However, when you buy
something in the spot market, you enjoy interest or dividend on the instrument. So the present
value of interest or dividend is deducted from the current spot price to get the present value
under the spot contract. This is the present value under the futures contract is the present value
under the spot contract. If the two diverge, arbitragers will step in and eliminate the disparity.

What is the relationship between futures price and spot price? On the left hand side is the
present value of the futures price. On the right hand side is the present value of the spot contract.
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any logo,
data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 4

When you enter into a spot contract, For a commodity you pay the spot price since you get the
commodity you have to store the commodity So there is a cost associated with the storage of
the commodity The present value of the storage cost has to be added to the spot price Of course
when you buy something in the spot market you have the convenience yield available to you.

If you buy aluminum in the spot market, you can use aluminum for your production purposes.
Such convenience is not available in a futures contract. If you buy a futures contract for
aluminum, you cannot use the contract. For your production purposes. So on the right hand
side, we have the present value of the spot contract as a sum of three things spot price plus
present value of storage cost minus present value of convenience yield.

Let us look at a solved problem. The stock index is currently at 1400 and one year stock index
futures is trading at 1500. The risk free annual rate is 11%. What is the average annual dividend
yield on the stocks in the index? We set up this equation in this equation on the left hand side
is the present value of the futures contract on the right hand side is the present value of the spot
contract.

In this equation, futures price is known, risk free rate is known, spot price is known, dividend
yield is not known, interest rate, risk free interest rate is known. We solve this equation for
dividend yield and find that it is 0.038 or 3.8 percent. Here is a solved problem relating to
commodity futures.

The following information is available for steel scrap. Spot price rupees 4,500 per ton futures
price rupees 5,000 for one year contract. Risk free rate of interest 12 present value storage cost
rupees 200. What is the present value of convenience yield of steel scrap? We set up an equation
like this on the left hand side. Is the present value the futures price on the right hand side. Is
spot price plus present value of storage cost minus present value of convenience yield.

In this equation, futures price is rupees 5000, risk free rate of interest is 12%, spot price is
rupees 4500, present value of storage cost is rupees 200. Solving this equation for present value
of convenience yield, we find that the present value of convenience yield is rupees 235.7 per
ton.

A forward rate agreement or an FRA is a forward contract for a short term loan at a rate of
interest that is specified today.
For example, a 329 FRA is a three month forward contract on a six month loan. The notional
amount and the FRA rate have to be specified. Let us assume that the notional amount is 100
million USD and the FRA rate is 4.2 percent. After three months, the reference rate would be
known. And the FR a's cash settle.

Suppose the reference rate after three months turns out to be 4.4%. In this case, the buyer of
the FRA will benefit because the buyer has contracted to take a loan at a rate of six 4.2%, but
the reference rate turns out to be 4.4%, so the buyer will get the difference. The buyer is entitled
to receive a payment equal to, Notional amount multiplied by the difference between the
reference rate, which is 4.4 percent and FRA rate, which is 4.2 percent multiplied by number
of days during that six month period divided by basis. The basis is either 360 days or 365 days,
depending on the currency in with the FRA has been done.

This benefit that the buyer is entitled to is receivable at the end of the period. So it has to be
discounted for that six month period. In our example, the notional amount is a hundred million
USD. Reference rate is 4.4%. FRA rate is 4.2%. Number of days is 184 basis is 360. This is
the amount receivable by the buyer of the FRA, but it will be receivable after six months.

So, this has to be discounted for a six month period. The numerator of this ratio shows the
amount the buyer of the FRA has to receive. Since this amount is receivable 184 days later, it
is discounted for 184 days at the reference rate and paid to the buyer.

Swaps

Hello learners and welcome back. A swap contract is an agreement between two parties to
exchange one set of cash flows for another. In essence, it to the portfolio forward contracts.
While a forward contract involves one exchange that a specific future date has swap contract
in days, multiple exchanges over a period of time.

There are three kinds of commonly used swaps, principle only swap, interest rate swap, and
currency swap.

Principle only swap: Under a principle only swap, there is an exchange swap. between two
currencies. IRFC, for example, entered into a principle only swap with banks. Under this swap,
it replaced USD 80 million euro currency borrowing with Indian national [Link] would
pay USD 80 million to IRFC in five equal installments of USD 16 million each. IRFC in turn
would pay rupee equivalent at a predetermined conversion rate.

An interest rate swap is a transaction involving exchange of one stream of interest obligations
for another. Typically it results in an exchange of fixed rate interest payments for floating rate
interest payments. Occasionally, it involves an exchange of one stream of floating rate interest
payments for another. The principal features of an interest rate swap are,

1. it effectively translates the A floating rate borrowing into a fixed rate borrowing and vice
versa. The net interest differential is paid or received as the case may be.
2. there is no exchange of principal repayment obligations.
3. It is structured as a separate contract. distinct from the underlying loan agreement.
4. it is applicable to new as well as existing borrowing.
5. it is treated as an off the balance sheet transaction.

To understand how an interest rate swap works, let us look at an [Link] A can raise
a loan of 100 million US dollars in the floating rate market at LIBOR. It can raise a loan of
seven years maturity at LIBOR and it expects the LIBOR to vary in this manner over a seven
year period. It is however interested in converting its LIBOR obligation into a fixed rate
obligation and a swap bank quotes a fixed rate of 7.5 percent. When the swap is done, the swap
bank will pay the firm the LIBOR floating rate. In turn, the firm will pay the swap bank a fixed

rate of 7.5%. So the net cash flow from swap would be as shown here. In year one, when
LIBOR floating is 6.5 percent and a loan of 100 million in days. an interest burden of 6.5
million the firm receives 6.5 million from the swap bank in turn it pays swap bank 7.5 million
so the net cash flow for the firm is minus 1 million. In year two when the LIBOR floating is
seven percent the firm has to pay a net amount of 0.5 million. In year three when the LIBOR
floating happens to be 7.5%. There is no exchange whatsoever. In year four, when the LIBOR
floating happens to be 8%, the firm receives 0. 5%. So these are the net cash flows to the firm
from the swap and the net payments to the firm on account of that loan are shown here.
Generally, when a firm wants to convert a floating rate loan into a fixed rate loan or vice versa,
it approaches a swap bank.

The swap bank in turn finds a counterparty so that the interest of the two parties are matched
and the swap bank serves as an intermediary. Let us look at an example to understand how this
works. Amit Limited is interested in fixed rate loans. borrowing of 50 million USD. Sumit
Limited is interested in a floating rate borrowing of 50 million USD. In the fixed rate loan
market, Amit Limited can raise at 7%. In the floating rate loan market, Amit Limited can raise
at LIBOR plus 50 basis point. Sumit Limited can raise money in fixed rate market at 5 percent
in the floating rate loan market at LIBOR. We find that Sumit Limited has an absolute
advantage in both the markets.

In the fixed rate market, it can borrow at 5 percent whereas Amit Limited has to pay 7%. In the
floating rate loan market, it can borrow at LIBOR and has to pay LIBOR plus 50 basis point.
However, Amit Limited has a comparative advantage in the floating rate loan market. In the
floating rate loan market, it has to pay only 50 basis point more.

In the fixed rate loan market, it has to pay 2 percent more. So, Amit Limited is well advised to
raise money in the floating rate loan market where it has a comparative advantage and convert
that into a fixed rate loan. Sumit Limited has an advantage in the fixed rate market, so it should
raise money in the fixed rate market and swap it into a floating rate loan. This is how it will
work when the swap bank charges 50 basis points for intermediation. Amith limited raises 50
million dollars in the floating rate loan market at LIBOR plus 50 basis points. It receives
LIBOR from the swap bank. It pays six percent fixed rate to the swap bank.

As a result, its liability is now only 6.5 percent fixed rate. You can see why. It pays 6 percent
here. It receives LIBOR here. It pays LIBOR plus 50 basis points. So its total burden is 6.5%.
If it were to raise money directly in the fixed rate loan market, it will have to pay 7 percent
since it seeks a fixed rate loan, it is advantageous for it to first borrow in the floating rate loan
market and do the swap.

Let us look at the picture for Sumit Limited. Sumit Limited has a comparative advantage in the
fixed rate loan market. So it raises money in the fixed rate loan market at 5%. It pays LIBOR
to the swap bank, it receives a fixed rate of 5.5 percent from the swap bank. So as far as Sumit
Limited is concerned, its effective cost is now LIBOR minus 50 basis point.

It pays LIBOR, it receives 5.5 percent fixed rate, it pays 5 percent fixed rate. So its net cost is
LIBOR minus 50. 50 basis point. If it were to approach the floating rate loan market directly,
it will have to pay LIBOR. By doing this swap, it has reduced its cost by 50 basis point. Amith
Limited also has reduced its cost by 50 basis point and the intermediary also gets 50 basis point.

A default swap is a credit derivative to protect against default risk. For example, company A
agrees to pay a fixed amount annually to company B as long as C, a debtor of company A, does
not default. In return, company B promises to compensate company A should company C
default. Essentially, company A is buying an insurance from company B and and paying an
annual premium to company B.

In a currency swap, both the principal and interest in one currency are swapped for principal
and interest in another currency. On maturity, the principal amounts are swapped back. Thus,
a currency swap involves
1. An exchange of principal amounts today,
2. An exchange of interest payments during the currency of the loans.
3. A re-exchange of principal amounts at the time of maturity.

Let us look at an example to understand how a currency swap works. Hitech Limited is an
American company very well known in the US capital market. Hitech Limited wants to set up
an operation in UK for which it requires 100 million pounds.

Hitech is not Known well in the UK capital market. So, Hitech raises 120 capital market at an
interest rate of 5%, which are equivalent to a hundred million pounds. So initially this is the
exchange between Hitech limited and the swap bank. Hitech limited gives swap bank 120
million, which it would have raised in the US capital market.

In turn, Hitech Limited gets 100 million pounds, which it uses for its UK operations. During
the currency of the loan, Hitech Limited receives 6 million dollars from the Swap Bank, which
it uses to pay interest on its US dollar borrowing. Hitech Limited, in turn, pays 4 million
pounds. Pounds to the swap bank because swap bank would have raised hundred million
pounds at an interest rate of four percent at the time of maturity high tech limited would receive
120 million dollars from the swap bank which it uses to repay its principal obligation on the
U.S dollar loan in turn high tech limited pays 100 million pounds to the swap bank.

Management of Forex Exposure

Hello learners and welcome back. Management of forex exposure is an important aspect of
financial management. We'll discuss the types of exposure, steps involved in managing
currency exposure, makes examples, some good practices in managing transaction exposure
and managing operating exposure. There are three kinds of foreign exchange exposures.
Transaction exposure, translation exposure and Operating exposure.

Transaction exposure, when a firm has a payable or receivable denominated in a foreign

currency, a change in the exchange rate will alter the amount of local currency received or paid.
Such a risk or exposure is referred to as a transaction exposure.
For example, if an Indian exporter has a receivable of a hundred thousand dollars due three
months, hence, and if in the meanwhile, the dollar depreciates relative to the rupee, a cash loss
occurs. Conversely, if the dollar appreciates relative to rupee, a cash gain occurs. In the case of
a payable, the outcome is of an opposite kind, a depreciation dollar relative to the rupee results
in gain. There is an appreciation of the dollar relative to the repeat results in the loss.

Translation exposure, also called accounting exposure, STEM from the need to convert the
financial statements of foreign operations from foreign currencies to domestic currency for
purpose of reporting and consolidation.

If there is a change in exchange rates since the previous reporting period, the translation or
restatement of foreign currency denominated assets, Liabilities, revenues and expenses will
result in foreign exchange gains or losses. Translation gains or losses do not involve cash flows
as they are purely paper gains or losses except when they have some tax implications.

Operating exposure is also called economic exposure. Operating exposure, like transaction
exposure, involves an actual or potential gain or loss, while the former is specific to a
transaction, the latter, much broader in nature, relates to an entire investment. The essence of
operating exposure is that exchange rate changes significantly alter the cost of a firm's inputs
and the prices of its output, and thereby influence its competitive position substantially.

An example may be given to explain the concept of operating exposure. Volkswagen had a
highly successful export market for its Beetle model in the U.S. before 1970. With the

breakdown of the Bretton Woods system of fixed exchange rates, Volkswagen The Deutsche
Mark appreciated significantly against the dollar. This created problems for Volkswagen as its
expenses were mainly in Deutsche Mark, but its revenues in dollars. However, in a highly price
sensitive U.S. market, such an action caused a sharp decrease in sales volume from 600,000
vehicles in 1968 to 200,000 in 1976. Incidentally, Volkswagens 1973 losses were the highest
as of that year suffered by any company anywhere in the world.

There are three broad steps involved in managing currency exposure.

Step one, identify the exposure. Direct exposures arise on account of imports, exports, and
borrowings in foreign currencies. Indirect exposures arise on account of import parity pricing.
Even though a firm may not be exporting or importing the prices of the goods that it produces
and sells in the domestic market will be influenced by the prices of similar goods in
international markets. For example, a steel company in India which produces only for the
domestic market is exposed to the risk of fluctuation of steel price internationally.

Step two, choose scenarios for the rupee. A common practice is to look at quarterly adverse
variation of 10 percent.

Step three, Choose the hedging strategy. A firm may have to decide how much of its exposure
should it hedge.

Merck has fairly well thought through foreign exchange risk management program. Merck is
a leading multinational pharmaceutical company headquartered in the U.S. It sells in more than
10 countries. Its overseas sales account for more than 50 percent and they are made in local
currencies. Merck spends substantial sums on R&D, which is critical for its competitive
strength. The major concern for Merck is to ensure that it has funds for its R&D program. So
the thrust of its risk management program is to ensure that Merck has adequate funds for R&D.

The steps involved in the risk management program of Merck are as follows.
1. Project exchange rate volatility, Project the probability of adverse exchange rate movement.
2. Assess the impact of exchange rate volatility on its five year strategic plan, its ability to meet
R& D needs and dividend payment needs.
3. Decide on whether to hedge a certain exposure or not.

4. Select appropriate financial instruments, Merck relies largely on plain vanilla options.
5. Construct a hedging program. Merck has a multi year hedging program. Merck does partial
hedging, not hedging. Total hedging. Merck does not rely on far out of the money options.
What is a far out of the money option? A far out of the money option is an option which is
going to be valuable only if there is a wide movement in price.

Suppose I buy a car a call option on Reliance which gives me the right to buy the shares of
Reliance as 2600 rupees, but the current market price of Reliance is only 2000. So that call
option would be deemed as a far out of the money call option because Reliance price will have
to move beyond 2600 for that option to be valuable.

As Judy Lewent Merck said it, we shed risk to take more risk. Essentially, she is saying that
they shed or transfer exchange rate risk so that they can take more business risk and R& D risk.

Here are some good practices for managing forex exposure.

1. Use simple derivative products. They are called a plain vanilla product. Avoid complex and
exotic products.
2. Identify contingent exposure when a bid is made and buy out of the money option contracts.
3. Recognize contractual exposure the moment a contract is signed, even though there may be
no letter of credit, even though goods may not have been shipped, even though invoices may
not have been raised.
4. Manage net exposures and decide how much of the net exposure would the company like to
hedge. 100%, 75%, 50%, 0 % or some other percent.
5. Specify maximum portfolio loss in a year on account of open positions and divide it into
quarterly limits.
6. Even though an exposure may be left open, it is advisable to apply stock loss in relation to a
benchmark rate, which is usually the forward rate.
7. Maintain EEFC or Exchange Earners Foreign Currency in each major currency of the
company's receipts and payments. The object is not to earn exchange profit but match receipts
and payments. and reduce transaction costs.

A commodity spread is used by a firm which buys raw material from abroad and sells final
products in overseas market. The firm buys commodity futures and sells product futures. It

locks in the operating margin. For example, crack spread is a difference between the price of
crude oil and the price of refined oil products.

The most popular risk management tools in India are forward, swaps, options, and futures.
Companies seem to have a strong preference for forwards and swaps over futures and options
and this preference is because they would like to do risk hedging through the banking system
rather than the capital market. Perhaps banks are able to customize a risk management solution
to the specific needs of the company, much better than the capital market.

Most companies use derivatives routinely for managing foreign exchange risk. Reliance
Industries Ltd relies heavily on forward contracts, option contracts, and currency swaps
because its key input crude oil is purchased in US dollars and the bulk of its output exported.
Further, it has significant position borrowings in US dollars. TCS uses heavily option contracts
for hedging its US dollar denominated receivables. Options make sense when the exchange
rate is very volatile.

Maruti Suzuki uses mainly forward Indian National Rupee, Japanese Yen contracts because of
its obligations for paying royalties and taxes a significant amount of imports from Japan in yen.

There are three broad policies with respect to risk management.

100 percent hedging, 0 percent hedging, selective hedging, and trading. Under 100 percent
hedging, all exposures are hedged. Under 0 percent hedging, no exposure is hedged. Under
selective hedging, some exposures are hedged, some are unhedged. In addition trading is also
done.

What are the risk reward implications of these three policies?

This policy entails low risk and low reward. This policy entails high risk and low reward. This
policy entails high risk and high reward. Obviously, this is a suboptimal policy. The firm may
have to choose between this or this.

What is the role of treasury function? Under 100 percent hedging, treasury function is a pure
housekeeping function. It is a cost center. Under 0 percent hedging, treasury function is
redundant. Under selective hedging and trading, treasury function is treated as a profit center
and transfer pricing becomes very important because operating divisions are given a price
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any logo,
data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 4

which reflects the forward price and the treasury department is treated as an operating profit
center.

Management of operating exposure -Transaction exposure is short term in nature and well
identified. Operating exposure on the other hand is long term in nature and can scarcely be
identified with precision. So the instruments of financial hedging, forwards, options and so on
which are helpful in hedging short term well defined transaction exposures are not of much
help in hedging. Managing operating exposure calls for designing the firm's marketing,
production, financing strategy to protect the firm's earning power in the wake of exchange rate
fluctuations.

The important levers for managing operating exposure are product strategy, pricing strategy,
plant location, sourcing, product cycle, liability structure.

Management of Strategic Risks

Hello learners and welcome back. Firms are subject to a variety of strategic risks. The seven
major classes of Strategic Risk are shown here.
Industry margins squeeze due to greater competitive intensity.
Technology shift, the emergence of a new technology may cast shadow over the future of a
firm.
Brand erosion, however powerful a brand may be, it may erode over a period of time.
One of a kind competitor, a new competitor with a new business design may disrupt an
industry.
Customer priority shift, customer priorities and preferences tend to shift over a period of
time.
New project failure, how well conceived and formulated a project may be, it is subject to a
number of risks.
Market stagnation - After a while, markets tend to stagnate.

Let us examine the key strategic risks and the response that is appropriate for these risks.
Industry margin squeeze, pharma industry has been experiencing diminishing R&D
productivity, semiconductor industry has been experiencing rising capex, airlines have
undergone deregulation. All these have led to industry margin squeeze. The appropriate
response to industry margin squeeze is to shift the compete collaborate ratio. Most companies
do too little and too late. The notable exception is Airbus consortium.

Technology risk abrupt shift in technology can hurt an industry. Digital imaging shrank the
market for film based photography. The appropriate response to technology shift is double
betting. Microsoft took a bet on OS2 as well as Windows operating system.

Similarly, like Intel took a bet on RISC and CISC chip architectures. Motorola failed to pursue
analog and digital cellular phone technologies and suffered grievously.

One of a kind competitor, Walmart, threatened the other players by its unique business model.
In the wake of such a risk. One must change business design to minimize strategic overlap with
the unique competitor while others succumb to Walmart, Target modified its business design
to capture some slices of the market.

New project failure more often than not new business project flounder. An appropriate response
to such possibilities of project failure is to smartly sequence the project and use the stepping
stone method.

Operational risk can be mitigated by having well documented standard operating procedures,
sound internal audit system, effective whistleblower policy, and vigilance check over corporate
frauds.

A great example of operational risk management is Morgan Stanley. 2,700 employees of

Morgan Stanley worked in the World Trade Center occupying 22 floors of the South Tower on
9 November 11, 2001, when the first plane hit the North Tower at 8:46 AM, Morgan Stanley
began its evacuation exercise at 8:47 AM.

When the second plane hit the South Tower 15 minutes later, Morgan Stanley's offices were
largely emptied. They suffered only seven casualties. Soon after the 1993 attack on the World
Trade Center, senior management recognized vulnerability. They initiated a program for
preparedness under the leadership of their vice-president security, Mr. Rescorla. He came from
a military background and he instituted a fire drill. On that fateful morning, Rescorla used a
bullhorn to tell employees to stay calm and follow the well practiced drill. Sadly, he didn't
survive. Morgan Stanley had prepared itself for a very tough reality. It had not just one, but
three recovery sites where employees could congregate and resume work.

Business firms are subject to a wide range of legal and compliance requirements. Legal and
compliance risk has increased over a period of time. No wonder corporate boards spend a very
substantial part of time Looking into various compliance issues, companies which have a sound
legal and compliance risk management program develop elaborate checklists for various
regulations and create a strong compliance culture.

Guidelines for Risk Management

Hello learners and welcome back. Here are seven key guidelines for Risk Management.
1. Align risk management with corporate strategy. Risk management should subserve corporate
strategy. Risk management should facilitate value creation strategies. We have seen in the case
of Merck that risk management is used to promote value creating strategy.

2. Proactively manage uncertainties. We live in a very unpredictable world. So, Companies

should learn to proactively anticipate risk and manage them rather than react to risk as and
when they arrive.

3. Employ a mix of real and financial methods. Firms used Real methods such as
diversification, strategic alliance, and so on, and they also use financial methods like forwards,
futures, swaps, and options. A judicious combination of real and financial methods is often
advisable.

4. Know the limits of risk management tools. It is easy to get carried away by exotic risk
management tools. One must know the limitations of risk management. These doors end here.
Use the tools very, very carefully.

5. Don't put undue pressure on corporate treasuries to generate profits. It is quite tempting at
times to regard corporate treasury as a very important source of profits for the firm. If such a
pressure is put on corporate treasuries, they are likely to speculate in a reckless manner.

6. Properly document the risk management strategy. It is It's imperative that a firm spells out
its risk management policy and documents it. It enables a firm to respond to risk in a reflective
manner, not a reflexive manner.

7. Reduce vulnerability. Firms should enhance their financial strength. Firms should build
financial resilience in order to become less vulnerable to external shocks.

Many companies where treasuries have resorted to speculation under an expectation to produce
profits have suffered grievous losses. Here are some examples. Metagesil Shaft, a German
metals and oil trading company, suffered a loss of about 1.3 billion from oil futures.

Showa Shell, a Japanese company, incurred a loss of 1.5 billion from foreign exchange futures.

Baring Brothers, a whorey British bank, collapsed when a rogue trader in its Singapore office
took huge positions in the Nikkei index futures and incurred a loss of 1.4 billion dollars.

Here are some important lessons. One senior manager should regularly monitor the risk
associated with the derivatives position taken by the firm. Two, the firm should speculate on
derivatives only when it has a comparative advantage in doing so. Three, a properly articulated
policy for managing financial risk is an integral part of a firm's internal control system.

Remember the principle that the less we articulate our expectations, the more likely are we to
be disappointed. An important guideline in risk management is to spread risk ownership
throughout the company by giving its operating managers the information and incentives to
choose the optimal trade off between risk and return.

A company improves its ability to execute its strategic plan. Those who are close to operating
risk are generally more qualified to handle them, so decisions to manage operating risk may be
entrusted to line managers who can rely on their knowledge of the business, supplemented by
technical advice where necessary.

Bill Gates is a strong believer in spreading ownership of risk by empowering people with
information on the intranet. Gates explains, “A company's metal managers and line employees,
not just its high level executors, need to see data. Companies should spend less time protecting
financial data from employees and more time teaching them to analyze and act on it.”

The last point, namely, reduced vulnerability, requires emphasis. Thanks to the internet and
globalization, the world has become a complex system comprising of a tangled web of inter-
dependent factors. In such a complex environment, black swan events have become more
common.

In the words of Nasim Taleb, “a black swan has three attributes. One, it is an outlier as it lies
outside the realm of regular expectations. Two, it carries an extreme impact. Three, the human
nature makes us concoct explanations for its occurrence after the fact. making it explainable
and predictable. These events make forecasting a futile exercise. So instead of trying to

anticipate low probability, high impact events, we should make ourselves less vulnerable to
them. An organization has to develop enormous financial resilience to cope with such black
swan events.

As says, I stick my neck out and make a claim against many of our habits of thought, that our
world is dominated by the extreme, the unknown, and the very improbable, improbable
according to our current knowledge.

And all the while we spend our time engaged in small talk, focusing on the known and the
repeated. This implies the need to use the extreme event. as a starting point and not treat it as
an exception to be pushed under the rug. I also make the bolder and more annoying claim that
in spite of our progress and the growth of knowledge or perhaps because of such progress and
growth, the future will be increasingly less predictable while both human nature and social
science seem to conspire to hide the idea from us.”

Risk management has important behavioral dimensions. Risk management is all about
managing ourselves, managing our ego, our arrogance, our stubbornness, our mistakes.

It is not about fancy quantitative techniques, but about making good decisions in the face of
uncertainty, scanty information, and competing demands. We find a very interesting
transformation in corporate control in the era of railroads, manufacturing dominated. When
conglomeration became fashionable, marketing emerged as an important force. When raising
finance became the biggest concern, finance assumed a central role. In the present era where
risks are multiplying, risk professionals have acquired a great stature.

In a very insightful book titled Against Gods, The Story of Risk, Peter Bernstein, perhaps the
most eminent financial historian of our time, argues that our view about risk depends on the
temper of time.

He looked at how humans have viewed risk in the long history of mankind. Before the arrival
of man. Christianity people felt that they had no control over the future and chance explained
every outcome. In this environment, oracles and priests thrived. With the arrival of Christianity,
random chance was out and gods will prevail.

From mid 1550s, the spirit of renounce flowered and during that period, scientific spirit
blossomed, theory of probability was developed, and the world seemed fairly predictable. After
World War I, a world that seemed predictable turned out to be unpredictable, and this
uncertainty prevailed till the end of the Second World War.

When things started stabilizing and normalizing from 1950s onwards, optimism prevailed. And
during this environment, classical capital ideas were developed. If you look at major classical
capital ideas, such as modern portfolio theory, capital asset pricing model, efficient market
hypothesis, and option pricing model, they all were developed during this period of optimism
from 1950s to 1980s.

In late 1990s, it appeared that dark and hidden forces were dawning on this world and this
feeling continues even today. In the last 20 years, we have seen several crises, particularly the
global financial crisis and the COVID 19 crisis, which appears as black swan events and the
world seems to appear more unpredictable.

For example, John Kay and Mervyn King have written a fascinating book called “The Radical
Uncertainty”, in which they argue that we seem to be living at a time of radical uncertainty. A
perusal of top ten risks by likelihood and impact for the last five years shows that most risks
are social, geopolitical, and [Link] contrasts with risks 15 to 20 years back when
financial risks were considered to be major risks.

Most companies are not geared to assess and manage risks of this kind. It's worth looking at
what is happening to risk management in India.

1. Post 2008 crisis, a greater focus on risk management has been accorded in corporate decision
making.

2. The major risks on corporate radar are currency risk, operational risk, credit risk, reputation
risk, strategic risk, interest rate risk, and commodity risk.

3. There is a growing realization that a structured approach involving probable scenarios is far
more desirable. Then reliance on market gurus.

4. Dedicated treasury teams have been created for centralized risk management. These are
regarded as profit centers as an offshore transfer pricing has become very important.

5. In the wake of derivatives crisis, huge losses were incurred by companies which took
positions in exotic derivatives and welcomed a no upfront premium associated with derivatives.
Now the primary reliance is on simple forward contracts. The secondary reliance is on plain
money law option contracts.

6. Thanks to mark to market accounting, treasuries have begun to realize the importance of
accounting impact.

7. Leading companies are now using value at risk, cash flow at risk, and Monte Carlo
simulation.

8. Commodity risk management has been somewhat neglected. However, there It's importance
is now being gradually realized.

Infosys has been a pioneer in risk management in India. It first articulated its risk management
policy in late 1990s. The elements of that policy were

1. No single vertical should account for more than 25 percent of revenues.

2. No single client should account for more than 10 percent of revenues.
3. The company should become more geographically diversified.
4. The company should be a zero debt company.
5. At least 40 percent of assets must be in liquid form.
6. The proportion of variable compensation should increase.

Over a period of time, Infosys has developed a comprehensive and integrated approach to risk
management called the Enterprise Risk Management or ERM.

ERM at Infosys encompasses identification, assessment, monitoring, and mitigation of various

risks associated with business. ERM at Infosys seeks to minimize risk. adverse impact on
business objectives and sustain and enhance the long term competitive advantage of the

company. ARM at Infosys is integral to its business model described as predictable,

sustainable, profitable, and de risked or PSPD model.

The approach to risk management has changed significantly in the last few decades,
particularly in leading companies. Earlier, risk management was done in a piecemeal manner.
Now, risk management is done in a holistic manner. Earlier, risk management was the concern
of few executives. Now, risk management is the concern of all managers of the firm. Earlier,
the thrust of risk management was on smoothing of income. Now, the thrust of risk
management is on sustaining value creating strategies. Earlier, risk management was done in a
somewhat ad hoc manner. Now, risk management is being done in a structured and systematic
manner. Earlier, hedging against known risk was the emphasis of risk management. Now the
thrust of risk management is to diminish vulnerability against unknown risks.

Risk Management – Module Summary

Hello learners and welcome back. We have covered a vast terrain. It is time to summarize the
wide array of risks that a business firm is exposed to may be classified into several categories.
Technological risk, economic risk, financial risk, performance risk, legal and statutory risk.
people risk, geopolitical risk, and environmental risks.

The uncertainties of doing business have increased since the early 1990s, thanks to
globalization, advances in technology, deregulation, and so on. In the wake of these
developments, the risk management perspective in progressive companies are shifting from
fragmented, ad hoc, and narrow approach to an integrated, continuous, and broad approach.

The key steps in integrated risk management are identify risk, measure risk, develop a risk
response strategy, integrate risk, and institute a risk infrastructure. Basically, a firm can do
three things with risk, risk reduction, and risk management. risk retention and risk transfer. A
firm can modify its operations in various ways to mitigate risk.

In addition, it can also change its financial structure. The principle of comparative advantage
is a very important principle in risk management. Forwards, futures, swaps, and options are
important financial tools of risk management. In coping with the complex problems of
managing corporate risk, the following guidelines should be borne in mind.
A. Manage risk in an integrated manner.
B. Align risk management with corporate strategy.
C. Employ a mix of real and financial methods.
D. spread risk ownership throughout the company. And
E, reduce vulnerability.

The four key takeaways for discussion are,

one, risk management should subserve value creation.
Two, the principle of comparative advantage should guide a firm about the risk to be borne and
the risk to be transferred.
Three, an integrated product Approved risk management should be developed.
Four, reduction of vulnerability has become very important given the radical uncertainty of our
times.

Here are some of the books that you may like to read Fooled by Randomness by Nassim Nikola
Stalib, The Black Swan again by Nassim Nikola Stalib and Fundamentals of Risk Management
by Paul Hopkins.
Thank you.

© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any logo,
data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
STRATEGIC FINANCIAL MANAGEMENT:
Managing For Shareholder Value

Week 4 – Corporate Risk Management

Contents:

Corporate Risk Management: Introduction - Key Steps in Risk Management -

Risk Measurement - Risk Mitigation Measures- Risk Transfer Mechanisms
(Forwards, Futures, Swaps, Options)- Management of Forex Exposure-
Management of Strategic and Other Risks- Guidelines for Risk Management -
Behavioural Aspects – Risk Management Practices.

STUDY PLAN

Week 4: CORPORATE RISK MANAGEMENT

• Watch Videos: Corporate Risk Management
• Study
➢ Reading – Week 4

• Solve the Practice Questions Pertaining to Week 4

READING WEEK 4: CORPORATE RISK MANAGEMENT

This reading is organized in to nine sections as follows:

• Array of Risks
• Risk Management Framework
• Key Points Relating to Financial Risk Management
• Value at Risk
• Risk Mitigation Measures • Spot and Futures Prices
• Forward Rate Agreement
• Merck’s Risk Management Strategy
• Strategic Risk Management

[Link] OF RISKS

No matter what its products and services are, every firm is exposed to risks. It is
virtually impossible to create a business which does not face risks. The wide array of
risks that a business firm is exposed to may be classified into six categories:
technological risks, economic risks, financial risks, performance risks, legal
/regulatory risks, and people risks.
Technological risks arise mostly in the R & D and operations stages of the value
chain. Companies in high-tech sectors and pharmaceutical industry are subject to
high R & D risks which can significantly impact their profitability. Operating risk
arises when new technologies lead to problems in production or in delivery of
services or when a production breakdown occurs or defective products lead to
product liability suits.
Economic risks stem from fluctuations in revenues (output price and demand) and
production costs (raw material cost, energy cost, and labour cost). General
macroeconomic conditions (like GNP growth rate) and the competitive environment
in which the firm operates determine the nature of economic risks.
Financial risks arise from the volatility of interest rates, currency rates, commodity
prices, and stock prices. While these risks are at the core of the operations of financial
services firms, they have a significant impact on non-financial companies as well.
Performance risks arise when the contracting counterparties do not fulfill their
obligations. For example, a supplier who has promised to supply a certain critical part
may fail to deliver.
Legal and regulatory risks arise from changes in laws and regulations. For example,
new environmental regulations may impose significant costs or a change in the tax
structure may alter the after-tax profitability of the firm.
People risks stem from the problems faced in recruiting, training, motivating, and
retaining talented and productive people.
Environmental risks stems form changes in the physical environment. Climate
change has now emerged as the greatest problem of mankind.
The uncertainties of doing business seem to have increased since the early 1990s,
thanks to the following forces: technology and the Internet, greater global
competition, deregulation of key industries, changing regulatory landscape, freer
flow of goods, services, and capital, higher customer expectations, and increase in
mergers, acquisitions, and corporate restructuring.
In the wake of these developments, the risk management perspective in progressive
companies is shifting from a fragmented, ad hoc, and narrow approach, to an
integrated, continuous, and broad approach. The new perspective is referred to as
integrated or corporate, or enterprise risk management.
[Link] MANAGEMENT FRAMEWORK
Given the detrimental consequences of high risk exposure, it behooves on every firm
to systematically manage its risk. A systematic approach to risk management involves
the following steps.

• Identify risks

• Measure risks

• Develop risk response strategy

• Integrate risks

• Institute risk infrastructure

Although these steps are inter-related in practice, for pedagogic purposes we will
discuss them sequentially.

Identify Risks Before a company sets out to manage risks, it must know the risks
that matter to it. For example, in DuPont’s early days, it was the risk of making
dynamite; for, ONGC, it is to find more oil; for Microsoft, it is to innovate continuously
before competitors encroach its territory. Yet in today’s dynamic, complex, and
global-based business, risk may not always be so apparent.

Measure Risks After identifying risks, the next step is to measure risks. At its
simplest, measurement involves simply ranking various risks. At the next, level it
involves imputing a monetary value, and at a still higher level it entails assigning
probabilities to them as well.
Risk measurement is most developed in the realm of financial risks. Value at risk
(VAR) and stress testing are the most common approaches for measuring and
assessing financial risks.
It is difficult to use sophisticated techniques like VAR or stress testing for
nonfinancial risk or operating risk. A lot of operating risk is so random that it is hard
to develop models that can serve as reasonable predictors. Perhaps one can take an
overall executive view of the system, develop risk metrics that make sense for the
specific business, and share best practices.
Of course, it must be recognised that it is not possible to measure some risks. While
enough data are available for the high frequency-low impact events, little data may
be available for the low frequency-high impact events. In the latter case, one may
operate on intuition and experience only.

Develop a Risk Response Strategy A company may choose to mitigate, transfer, or

accept risks. A company’s risk appetite (or that of its stakeholders) determines its
risk response strategy.
A company can mitigate its risk by making changes in its operations or its financial
structure. Some of the common ways of risk reduction are diversification,
outsourcing, strategic alliances, flexible production systems, extra liquidity, and so on.
Risk transfer can be effected through the following means: insurance, forwards or
futures, swaps, and options.
In deciding whether it should retain or transfer risks, a company must be guided by
the principle of comparative advantage.
The principle of comparative advantage reinforces the notion that companies are in the
business to take strategic and business risks. It makes sense for companies to reduce non-
core exposures so that they can take more strategic business risks and exploit the
opportunities in their core business. This is sometimes referred to as the paradox of risk
management.

Integrate Risks Ideally, a company should integrate risks and adopt an enterprise-
wide approach to risk management. This is easier said than done. While most
companies talk about enterprise-wide risk management, very few have successfully
implemented it.
Many companies continue to manage major risks in a piecemeal manner,
independent of one another. An important factor that contributes to such a
piecemeal approach is that professions are generally organized around a single skill
set, such as insurance, accounting, portfolio management, or actuarial science.
What is required is a wholistic approach to risk management. An effective ERM
ensures that no one type of risk receives excessive attention and resources at the
expense of other risks and risks are managed in an integrated fashion. It is necessary
to draw on expertise in different areas.

Institute a Risk Infrastructure A firm committed to an enterprise-wide approach

to risk management obviously requires a sound risk infrastructure which is
appropriate to its needs. For example, at DuPont the risk management committee
assists the CEO in setting risk management policies and guidelines and maintains
close contact with business units. The risk infrastructure at Microsoft is driven by
technology via intranet and ongoing personal communication between the risk
management group and the operating management.
[Link] POINTS RELATING TO FINANCIAL RISK MANAGEMENT

• Since the early 1970s financial prices, i.e., interest rates, exchange rates,
commodity prices, and equity prices, have become more volatile.
• The financial market responded to business needs for managing risk by
developing a range of risk management products like forwards, swaps, and
options. Many firms now use financial derivatives to tailor their exposures to
currency, interest rate, and commodity price risks.
• A forward contract is an agreement between two parties to exchange an asset
for cash at a predetermined future date for a price specified today. A futures is
a standardised forward contract. Broadly there are two types of futures:
commodity futures and financial futures.
• A swap contract is an agreement between two parties to exchange one set of
cash flows for another. In essence, it is a portfolio of forward contracts.
• In principle, a swap contract can be tailored to exchange just about everything.
In practice currency swaps and interest rate swaps are quite popular.
• In a currency swap, two parties agree to exchange a specific amount of one
currency with a specific amount of another at certain dates in future.

• An interest rate swap is a transaction involving an exchange of one stream of

interest for another. Typically, it results in an exchange of fixed rate interest
payments for floating rate interest payments.
• A commodity swap is a contract to exchange a specified quantity of a
commodity at a specified price at fixed times in future
• An option contract is an agreement under which the seller (or writer) of the
option grants the buyer (or holder) the right, but not the obligation, to buy or
sell (depending on whether it is a call option or put option) some assets at a
predetermined price during a specified period.
• When a firm buys insurance, it pays premium to shift the risk to the insurance
company.

[Link] AT RISK
Financial firms like banks, mutual funds, hedge funds, and so on hold portfolios of
risky traded assets. They are naturally concerned about the erosion in the value of
their investment portfolio. To measure their risk exposure, financial firms generally
calculate VAR. VAR reflects a limit on the loss of value of a portfolio, on account of
normal market movements, which will be exceeded only with a small pre-specified
probability. Thus, if VAR is 100 million (or whatever) with a confidence level of 95
percent, it means that there is a 5 percent probability that the loss in portfolio value
will exceed 100 million.
VAR can be computed for an individual asset, or a portfolio, or a firm. The Zth
quantile of a distribution is a number such that the probability that the random
variable will be below that number is Z percent and the probability that the random
variable will be above that number is (100 – Z) percent. The VAR at the probability
level of Z percent represents the loss that corresponds to the Zth quantile of the
cumulative probability distribution of the value change at the end of a given
measurement period. In formal terms, VAR is the number such as Prob (Loss > VAR)
= Z percent. While Z can be 1, 5, or any other number, we will use Z percent as 5
percent unless we specify otherwise.
If the portfolio return is normally distributed, computation of VAR is fairly straight
forward. A random variable that follows normal distribution can be transformed into
a random variable that follows the standard normal distribution (a standard normal
distribution has an expected value of 0 and a standard deviation of 1) by simply
subtracting the mean from the random variable and dividing the resulting variable
by the standard deviation of the random variable.
If x is a normally distributed random variable, u = [x – E(x)]/s (x) follows a standard
normal distribution which has an expected value of 0 and standard deviation of 1.
Hence, the fifth quantile of the distribution of x can be obtained from the fifth quantile
of u (which is –1.65). Thus, the formula for the fifth quantile of x is: Fifth quantile of
x = –1.65 x s (x) + E(x) .
To illustrate, suppose a bank has a portfolio of traded assets with an expected return
of 0.2 percent and standard deviation of 6 percent on a weekly basis. The fifth
quantile of the return distribution is: –1.65 x 6 percent + 0.2 percent = –9.70 percent.
For VAR, we consider the absolute value of the fifth quantile, or 9.70 percent. Hence,
if the bank’s portfolio is worth Rs. 100 billion, the VAR is 9.70 percent of Rs. 100
billion, or Rs. 9.70 billion.

[Link] MITIGATION MEASURES

A firm can mitigate risk by making changes in its operations and its financial

structure.

Changes in Operations
A firm can modify its operations in various ways to mitigate risk. Some of the ways of
doing so are:
Invest in Stages If you are not sure about the market response to your product or
service, you may start small and later expand as the market grows.
Improve Information An African proverb says “Don’t test the depth of a river with
both feet”. You may like to gather more information about the market and technology
before taking the plunge.
Shorten Time to Market One way to reduce uncertainty is to cut the time to market.
customer needs and preferences only two years, and not four years, in advance.
Pricing Strategy Pricing strategy is used by many firms to manage risk
Develop Contingency Plans Apart from taking steps to reduce risk to the extent it is
practical and feasible, well managed companies prepare for the worst.
Make Long-term Arrangements One way to mitigate risk is to enter into long-term
arrangements with suppliers, employees, lenders, and customers.
Enter into Strategic Alliance When the resources required for a project or the risks
inherent in a project are beyond the capacity of a single company, strategic alliance
may be the way out. Competitors are beginning to cooperate leading to a
phenomenon called ‘co-opetition.’
Build Greater Flexibility A firm can build greater flexibility in its manufacturing or
production process.
Outsource Outsourcing is widely used for reducing risk.
Diversify As most of the business are characterised by cyclicality or volatility or both,
it is desirable that there are at least three distinct lines of business in a firm’s
portfolio.

Changes in Financial Structure

The overall risk of a firm is a combination of its business risk and financial risk. We
discussed ways and means of mitigating the business risk. To contain financial risk,
companies typically reduce their debt-equity ratio and/or carry surplus liquidity.
Reduce Debt-Equity Ratio Most companies set a target debt-equity ratio that gives
them sufficient leeway to raise money for meeting unexpected needs.
Carry Surplus Liquidity Companies often carry some surplus liquidity to cope with
unforeseen needs.

[Link] AND FUTURES PRICES

Spot and Futures Prices: Financial Instruments

When you buy a security, you have a choice. You can buy it in the spot market and get
immediate delivery or you can buy in the futures market and obtain deferred delivery.
If you buy in the spot market, you make payment now and you are entitled to the
benefits of ownership (like dividend and interest) from now onwards. If you buy in
the futures market, you make payment at a specified time (designated as t) in future
and, hence, get the benefits of ownership from that point of time onwards.
These differences between purchases in the spot market and futures market
suggest the following relationship between the spot and futures prices.

The above formula may be illustrated with the help of an example. The stock index
currently is 2,000 and six months stock index futures is trading at 2,110. The risk-
free annual interest rate rf is 14.5 percent and the average annual dividend yield on
the stocks in the index is 3 percent. Is there consistency among these numbers?
Suppose you buy the six month stock index futures contract for 2,110. In order to
meet your obligation, you set aside an amount equal to:

Your payoff for this investment would be what you get by buying the stock index in
the spot market, except the dividend on it for the next six months. Assuming that the
dividend return for six months will be 1.5 percent, receivable at the end of the six
month period, the payoff will be:
Thus an investment of 1972 gives a payoff of 1972. Hence, the numbers are
internally consistent.

Spot and Futures Prices: Commodities

If you buy a commodity in the futures market, rather than the spot market, you gain
on two counts: (i) You can earn interest on your money, as your payment is deferred.
(ii) You save on storage, insurance, and wastage costs as you don’t have to store the
commodity. As against these advantages, you have to forego the convenience of
having the commodity readily on hand. For example, if you run out of your inventory
of aluminium you can’t replace it with aluminium futures.
Given the above advantages and disadvantages, one would expect the following
relationship to hold for commodities:

[Link] RATE AGREEMENT

A forward rate agreement (FRA) is a forward contract on a short-term loan, which is

cash-settled. For example, a 3 x 9 FRA is a 3-month forward contract on a 6-month
loan. This means that the loan commences at the end of 3 months and matures at the
end of 9 months. The interest rate on the loan, called the FRA rate, is determined
when the contract is first entered into. Because the FRA is cash-settled, no loan is ever
extended. The FRA is settled on the first day of the underlying loan, which is called
the settlement date. The formula for determining the payment is as follows:
notional (reference rate–FRA rate) days/basis

1(reference rate)days/basis
where notional is the notional amount of loan, reference rate is a benchmark rate
which is Libor or Euribor rate prevailing on the settlement date, FRA rate is the
forward contract rate, days is the number of days the loan is counted for using the
actual number of days in each month, and basis is the day count basis applicable to
money market transactions in the loan currency (360 days for USD or EUR and 365
days for GBP).

Example A 3 x 9 USD 100 million is transacted with an FRA rate of 4.2 %. There are
184 days in the loan period relating to this FRA and the 6-month Libor on the
settlement date is 4.4%. Since the reference rate (4.4%) in this case is higher than the
FRA rate (4.2%), on the settlement date, the borrower (the party that is long on FRA)
receives from the lender (the party that is short on FRA) the following amount.
100,000,000(0.044 0.042)184/360
= USD 99,974
1(0.044)184/360

8 MERCK’S RISK MANAGEMENT STRATEGY

Headquartered in the U.S., Merck is a leading multinational pharmaceutical company

that does business in more than 100 countries. More than 50 percent of its sales are
made abroad and foreign sales are billed in local currencies. Merck spends large sums
of money on R&D which is critical for its competitive strength. A major concern for
the management is that unexpected foreign exchange losses could curtail its R&D
outlays which are essential for its success. So, Merck’s risk management programme
is designed to reduce the likelihood of such an outcome.
Judy Lewent and John Kearney1 explain how Merck addressed the issues in five steps
when its risk management programme was put in place.
Step 1 Project exchange rate volatility Merck projects exchange rate volatility to
quantify the probability of adverse exchange rate movement.
Step 2 Assess the impact on the 5-year strategic plan Since cash flows are affected by
foreign exchange movements, Merck estimates the impact of adverse exchange rate
movement on the firm’s ability to meet its R&D needs and dividend payments.
Step 3 Decide whether to hedge the exposure Merck examines the desirability of
reducing earnings volatility due to exchange rate movement from both internal and
external perspectives. The main internal consideration is the firm’s ability to finance
R&D expenditures and the main external consideration is the firm’s ability to sustain
dividend growth.
Step 4 Select the appropriate financial instruments While there are several hedging
instruments, Merck decided to use plain vanilla options as the principal tool in its
hedging programme. The rationale for doing so was that it would preserve potential
gains, if the dollar weakened, while providing downside protection.
Step 5 Construct the hedging programme Merck’s risk management programme
involved hedging on a multi-year basis, avoiding far-out-of-the-money options, and
resorting only to partial hedging, which means self-insuring for the remainder.
( Based on Judy C. Lewent and John Kearney, “Identifying, Measuring, and Hedging
Currency Risk at Merck.” In Donald H. Chew (ed), The New Corporate Finance,
McGraw-Hill, 1999).

[Link] RISK MANAGEMENT

A. Slywotzky and J. Drzik, in their article, “Countering the Biggest Risk of All,”
(Harvard Business Review, April 2005), argue that while companies are becoming
more adept at managing financial, operational, and catastrophic risks, not many
managers systematically address strategic risks that may erode value. This is largely
due to the complexity of the concept of strategic risk, as no single quantitative
measure is satisfactory in all strategic situations. Indeed, quantifiable risks receive a
great deal of attention from academic researchers as well as practitioners, while “soft
risks,” however significant, tend to get neglected. As presented in Exhibit 1, they
classify strategic risk into seven major categories and suggest measures to counter
them.

Exhibit1. Seven Major Classes of Strategic Risk

(Adapted from Prasanna Chandra, Strategic Financial Management,2nd edition,

McGraw Hill).
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 1: Strategic Financial Management:
Managing for Shareholder Value

PRACTICE QUESTIONS

Week 4

RISK MANAGEMENT

DP-1Consider the following data

Amit Ltd Sumit Ltd
a. Desired Funding Fixed Rate Floating Rate
b. Cost of Fixed Rate Funding 7.0% 5.0%
c. Cost of Floating Rate Funding 6- month LIBOR +50 bp. 6 month LIBOR

Show how both parties can save on funding costs by entering into an interest-rate swap with
the help of a swap bank. Assume that the bank wishes to earn 0.5 % and the balance of
savings is shared equally between the two firms.

DP-2. The stock index is currently at 1400 and the one year stock index futures is trading at
1500. The risk-free annual rate is 11 percent. What is the average annual dividend yield on
the stocks in the index?

DP-3. The following information is available for steel scrap:

• Spot price: 4500 per ton
• Futures price: 5000 for a one year contract
• Risk-free interest rate: 12 percent• PV (storage cost): 200 per ton per year
What is the PV (convenience yield) of steel scrap?

DP – 4 A bank’s portfolio of traded assets, currently worth 800 billion has an expected return
of 0.25 percent and standard deviation of 7 percent on a weekly basis. What is VAR at a
confidence level of 95 percent and 99 percent?

DP – 5 A 3x 9 USD 100 million is transacted with an FRA rate of 2.5%. There are 182 days
in the loan period relating to this FRA. The six- months Libor on the settlement date is 2.4%.
What will be the amount the borrower (the party that is long on FRA) pay or receive

© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course format on Swayam. No part of this document, including
any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 1: Strategic Financial Management:
Managing for Shareholder Value

Answer:

DP -1 –

DP-2 – 3.8%
DP 3 – Rs. 235.7 per ton

DP 4 - VaR at 95% confidence level = Rs.9.04 billion, VaR at 99% confidence level = Rs. 12.68
billion

DP 5 – (-) 49, 950 USD

© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course format on Swayam. No part of this document, including
any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.

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Corporate Risk Management Strategies

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Corporate Risk Management Strategies

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Strategic Financial Management:

Managing for Shareholder Value

Introduction to Risk Management

Key Steps in Risk Management

Identify risks: For example, TCS recognized risks as follows,

After identifying risk, the next step is to Measure Risk.

If X is a normally distributed random variable, U, which is defined as X minus expected value

Risk Transfer Mechanisms

Hello, learners, and welcome back.

No collateral is usually required in a forward contract. In a futures contract, collateral has to be

Marking to market a futures contract may be likened to a series of forward contracts in

Futures contracts have a tremendous appeal because of certain advantages.

Management of Forex Exposure

Transaction exposure, when a firm has a payable or receivable denominated in a foreign

There are three broad steps involved in managing currency exposure.

Here are some good practices for managing forex exposure.

There are three broad policies with respect to risk management.

What are the risk reward implications of these three policies?

Management of Strategic Risks

A great example of operational risk management is Morgan Stanley. 2,700 employees of

Guidelines for Risk Management

2. Proactively manage uncertainties. We live in a very unpredictable world. So, Companies

1. No single vertical should account for more than 25 percent of revenues.

ERM at Infosys encompasses identification, assessment, monitoring, and mitigation of various

company. ARM at Infosys is integral to its business model described as predictable,

Risk Management – Module Summary

The four key takeaways for discussion are,

Week 4 – Corporate Risk Management

Corporate Risk Management: Introduction - Key Steps in Risk Management -

Week 4: CORPORATE RISK MANAGEMENT

• Solve the Practice Questions Pertaining to Week 4

This reading is organized in to nine sections as follows:

• Develop risk response strategy

• Institute risk infrastructure

Develop a Risk Response Strategy A company may choose to mitigate, transfer, or

Institute a Risk Infrastructure A firm committed to an enterprise-wide approach

• An interest rate swap is a transaction involving an exchange of one stream of

[Link] MITIGATION MEASURES

Changes in Financial Structure

[Link] AND FUTURES PRICES

Spot and Futures Prices: Commodities

[Link] RATE AGREEMENT

A forward rate agreement (FRA) is a forward contract on a short-term loan, which is

8 MERCK’S RISK MANAGEMENT STRATEGY

Headquartered in the U.S., Merck is a leading multinational pharmaceutical company

[Link] RISK MANAGEMENT

Exhibit1. Seven Major Classes of Strategic Risk

(Adapted from Prasanna Chandra, Strategic Financial Management,2nd edition,

DP-1Consider the following data

DP-3. The following information is available for steel scrap:

DP 5 – (-) 49, 950 USD

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