SIM/NYU

The Job of the CFO

Financial Risk Management

Prof. Ian Giddy

New York University
 Risk Management is a Process

Corporate Risk Management

Define Measure Manage Monitor

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -5

 Financial Risk Management

 Why does it matter?

 Why and when should we hedge?
 What should we hedge? How should we
gauge exposure?

 Financial risk management must be tied

to the company’s business

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 The Case For Hedging

 Company has special information

 Company has special market access
 Secure cash for investment opportunities
 Reduce potential costs of financial distress,
increase debt capacity, and reduce expected
taxes
Since currency matching reduces the
probability of financial distress, it allows the
firm to have greater leverage and therefore a
greater tax shield.
Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -7
 Optimal Capital Structure

VALUE OF THE FIRM

HEDGING CAN
REDUCE COSTS
OF FINANCIAL
DISTRESS

ALL-EQUITY VALUE

DEBT
RATIO

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 Hedging, Valuation, Taxes and
Financial Distress

Negative Positive
net worth net worth

Profile of return to creditors

+
-
Costs of bankruptcy to creditors

Distribution of net worth with

hedging

Distribution of net worth

without hedging (or with
greater exchange rate
volatility)

Net worth of the firm

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 When Should Firms Hedge?

Business risk

Financial risk

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 Which Firms Should Hedge?
Characteristics of firms for which financial stress is
especially costly:
 Firms with:
 Products that require after-sale servicing
 Products whose quality is difficult to determine in
advance
 Products with high switching costs
 Products that rely on third-party servicing

 And firms that have:

 High-growth opportunities
 Intangible assets like firm-specific human capital
 Large excess tax deductions
Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -11
 What Exposure Should Firms Hedge?

 Currency risk
Transactions
Translation
exposure
Economic exposure
Interest
Rate Risk
Commodity Price Risk

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -12

 Measuring Market Exposure

 Defining corporate exposure:

“How will my company’s value be
affected by market price fluctuations?”
 Types of exposure
Transactions
Balancesheet/portfolio
Economic
 A risk management framework

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 How Effective is My Company’s Risk
Management?

Warning Signs:
 Don’t measure risk  Fragmented effort
 No linkage of risk to  Narrow focus
value  Poor risk
 No effort to anticipate communications
 Lack of business risk  Lack of an
policy integrated risk
assessment
framework
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 Formalize Risk Management Policy and
Control Framework

• Develop an outline of a policy

statement, or recommend
improvements to existing
document
Corporate Risk Management
• Benchmark controls versus best
practice using the Group of
Thirty Recommendations,
Treasury Management Define Measure Manage Monitor
Association Guidelines, or
accumulated knowledge of
appropriate practices
• Assess centralization issues
related to financial risk
management and treasury
design
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 Identification and Definition of
Financial Exposures

Goal: To identify significant financial risk exposures and

prioritize them in a manner consistent with
management's desired risk profile.
Translation Exposure, Absolute Rate Risk, Price Risk, Basis or
Transaction Exposure, and Convexity, Basis or Correlation Risk
Economic Exposure Correlation Risk
• Long-term versus short-term • Short-term liquidity portfolio • Procurement
exposure • Investment portfolio • Inventory
• Intracompany versus third
• Capital markets borrowing • Sales elasticity
party exposure
• Cross currency exposure • Leasing portfolio
• Competitive exposures

Currency Interest Rate Commodity

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 Market Risks: Definitions

Three Views of
Market Price Risk:
 Transactions
 BalanceSheet/Portfolio
 Economic risk.

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 Market Risks: Definitions

Three Views of
Market Price Risk: Transactions
Transactions
 Transactions Exposure
Exposure

 BalanceSheet/Portfolio
 Economic risk.

Portfolio
Portfolio Economic
Economic
Exposure
Exposure Exposure
Exposure

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 Transactions
Transactions
Exposure
Exposure

Transactions Exposure
Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure

 Transactions exposure results from

particular transactions such as an export
where a known cash flow in a given
currency will take place at a certain date
Example: If Nokia invoices a NTT of Japan in
Japanese yen for a celphone shipment then
the firm has Japanese yen exposure and can
hedge this by borrowing yen.
This kind of exposure is readily hedgable
using forwards, futures or debt

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 Transactions
Transactions

But Transactions Exposure

Exposure
Exposure

Can be Misleading... Portfolio

Portfolio
Economic
Economic
Exposure Exposure
Exposure Exposure

 Austin Computer purchases notebook

computers in Taiwan for sale in the US.
 Austin must pay in NT$.
 Should it hedge its anticipated
payments for 1996?

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -20

 Transactions
Transactions
Exposure
Exposure

Austin Computer
Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure

NT$

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -21

 Transactions
Transactions

Interest Rate Risk:

Exposure
Exposure

Portfolio Portfolio
Portfolio
Economic
Economic
Exposure Exposure
Exposure Exposure

 Portfolio risk: interest rate fluctuations

can affect the value of a bond
investment portfolio
 Bond price fluctuations will affect the
balance sheet
 Can be hedged, using duration as a
risk/sensitivity measurement tool
 Can be hedged with futures, bond
options, and swaps.
Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -22
 Transactions
Transactions
Exposure
Exposure

Pepsico Pension
Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure

Assets (each $10m): Pension liabilities:

 1-year E$ deposit  $10m 3 years
 5-year, 6% T-note  $10m 5 years
D=4.6  $10m 7 years
 10-year Strip

 What is Pepsico pension fund’s risk?

Duration of the assets (+ve)
Duration of the liabilities (-ve)
Net duration is the risk to be hedged!
Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -23
 Transactions
Transactions
Exposure
Exposure

Value at Risk: SantosBank

Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure

INSTRUMENT
SANTOSBANK
POSITIONS Asset and liability
30 day ($1,250,000)
90 day ($100,000) positions for a
180 day
1 yr
$450,000
$120,000
Brazilian bank’s
2 yr $120,000 New York branch.
3 yr $120,000
4 yr $1,120,000 What risk does it
5 yr $0
7 yr $0 face?
9 yr $0
10 yr ($420,000)
15 yr $0

NET $160,000
TOTAL $3,700,000

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -24

 Transactions
Transactions
Exposure
Exposure

BIS: Minimize Value at Risk

Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure

SANTOSBANK
INSTRUMENT POSITIONS
30 day ($1,250,000)
90 day ($100,000)
180 day $450,000

+
1 yr $120,000
2 yr $120,000
3 yr $120,000
4 yr $1,120,000
5 yr $0
7 yr $0
9 yr $0
10 yr ($420,000)
15 yr $0

NET $160,000
TOTAL $3,700,000

= Value-at-Risk
Value-at-Risk

Mean

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -25

 Transactions
Transactions
Exposure
Exposure

Market Price Risk: Economic Portfolio Economic

Portfolio Economic
Exposure Exposure
Exposure Exposure

 Economic risk arises from the real

business risk of the company,
insofar as it is tied to market
interest rates, FX, commodity
prices
 It affects the shareholder value, but
may be difficult to quantify
 Hedging may require tailored
solutions
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 Inmet Mining Corp.
 In 1994 Canadian mining company
Inmet bought 48% of Bougrine, a lead &
zinc mine in Tunisia. Inmet had to
borrow $33 million at a floating rate.
Should it hedge its cost of funds?
 Answer: Business exposure is to lead &
zinc prices (mine shutdown in Oct 96
because of low zinc prices)
 Hedge with digital option linking cost of
funds to lead & zinc prices

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -27

 Transactions
Transactions
Exposure
Exposure

Market Price Risks: Summary

Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure

Three Views of
Market Price Risk:
 Transactions - lock in
forward rate
 Portfolios
Avoid duration mismatching
 Minimize Value at Risk

 Economic risk - business

sensitivity to market prices.
Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -28
 “Most Important” Objective In
Using Derivatives To Hedge
Market Value of the Firm
8%

Volatility in Cashflow
Volatility in Earnings
49%
42%

CIBC Wood Gundy/Wharton

1995 End-User Survey
“Most Important” Objective In
Balance Sheet Accounts Using Derivatives To Hedge
Copyright ©2001 Ian H. Giddy [Link] 1% Financial Risk Management -29
 Next Step: Analyze Current
Exposure Measurement Techniques

Precision
Precisionof
ofthe
thedata
data

Risk Information
Sources: Time horizon of the
projections
•Current trade flow data
•Portfolio system reports Frequency of
reporting
•Accounting information
•Budgeted trade flow data
•Pricing practices Quantification Adequacy

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -30

 Corporate Exposure
Information Sources

Current trade flow data

Exposure
Portfolio system reports
Database
Hard
Accounting information

Budgeted trade flow data

Soft Economic exposure

estimates

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -32

 Exposure Database: Example

Exposure
Database

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -33

 From Data to Analysis

Exposure
Database

Exposure Measurement
System

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 A Management-Friendly Report

 An example is FourFifteen™, named

after J.P. Morgan's market risk report
produced at 4:15 p.m. each day.
 The "4:15 Report," a single sheet of
paper, summarizes the Daily Earnings
at Risk for J.P. Morgan worldwide.

Gov't Bonds Zero Cashflow

  Portfolio Risk Simulation
   RiskMetricsª
   USD Base. Vols. & correls. as of May 04, 1995.

           AUD
     CAD
BEF    DKK
   FFR
   DEM
    
ITL JPY
   NLG
   ESB
  SEK CHF   GBP 
XEU USD Total
   1 Mo      15 22   37
    
3 Mo    -200   20 -30       160 - 50
   6 Mo   25      -5 20


   12 Mo       -105 - 105
   2 Yr    0
   3 Yr    0


   4 Yr    0

($000)
   5 Yr    0
   7 Yr    0

RISK
   9 Yr    0
   10 Yr    0


   15 Yr    0
   20 Yr    0
   30 Yr    0


  Equity    0



    Implied
     - 196.1    59 22 -29       54 -145

     FX Spot
   23   23
 
 Net
     - 196.1    82 22 -29    -122


    Int.
      502     262 5 139       400 740


   Eq.

 
   
Fx     5,048    4265 1383 1820    8516
      
divers.     -200     -347 -6 -83    -451


     
Net     5,350    4181 1383 1876       400 8805

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -35

 Exposure Report: Example

Portfolio Risk Simulation RiskMetricsª

USD Base. Vols. & correls. as of May 04, 1995.

AUD BEF CAD DKK FFR DEM ITL J PY NLG ESB SEK CHF GBP XEU USD Total
1 Mo 15 22 37
Gov't Bonds Zero Cashflow

3 Mo -200 20 -30 160 - 50

6 Mo 25 -5 20
12 Mo -105 - 105
2 Yr 0
3 Yr 0
4 Yr 0
5 Yr 0
7 Yr 0
9 Yr 0
10 Yr 0
15 Yr 0
20 Yr 0
30 Yr 0

Equity 0

Implied - 196.1 59 22 -29 54 -145

FX Spot 23 23
Net - 196.1 82 22 -29 -122

Int. 740
RISK($000)

502 262 5 139 400

Eq.
Fx 5,048 4265 1383 1820 8516
divers. -200 -347 -6 -83 -451
Net 5,350 4181 1383 1876 400 8805

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -36

 Market Risk Measurement

Where are we now? Where do we need to be?

Option Value
Volumetric Duration/ Sensitivity Simulations at
PVof01 Measures Risk

• Notional • Linear risk • Non-linear risk • Limited market • Distribution of

Amounts measures measures scenarios that market moves and
• Swap/ bond • Delta, gamma, could include portfolio values
equivalents vega, theta, rho market • Includes market
• No aggregation of correlations correlations
risk measures • Reprice portfolio • Reprice portfolio
across asset • Parallel and non- • Aggregate risk
classes or parallel curve measures within
instruments shifts confidence interval
• Aggregate portfolio
risk per scenario
Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -37
 An Overview of Corporate VAR

Transactional
Business 1 Database

Portfolio
Business 2
Database

Business 3 Projected Revenues

Projected Operating Costs

Estimates of Cash Flow Distribution

Model 1
Base rates/
Currency market Interest Rates
conditions Mean
Model 2
• Volatilities Equities
• Correlations
Model 3
Commodities Impact on
Historical rates/ Earnings
Discrete scenarios Model 4
Currencies

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -38

 Analyze Exposure Management
Activities
•Multicurrency borrowing/ investing,
currency of invoice, &
Investigate commercially-based hedging
opportunities for techniques
natural offsets
•Financial instruments such as
Evaluate alternative forwards, futures, swaps and
hedging techniques options

•Expected and out-of-pocket costs,

Cost/benefit analysis
benefits and risks of potential
strategies; competitors’ actions

Strategic alignment •Accordance with overall corporate

policy and acceptable from an
accounting and regulatory
standpoint, if applicable

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -39

 Corporate Exposure Management:
Match Tools to Risks
Inflexible,
committed
Current trade flow data

Hard
Portfolio system reports

Accounting information

Budgeted trade flow data

Flexible,
Economic exposure optional
estimates
Soft
Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -40
 Most-Used Instruments
Hedge Identifiable Exposure

70%

60%

50%

40%

30%

20% Foreign Exchange

10% Interest Rates

0% Commodity Source of
Exposure
Forwards
Futures Equity
Swaps OTC
Exchange
Options Struct.
Type of Transaction Options Hybrid
Der.
Debt
1995 CIBC/Wharton End-User Survey
Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -41
 Market Views Impact
Corporate FX Hedging Decisions
80%

70% Sometimes
Frequently
60%

50%

61%
40%
48%
30%

33%
20%
Wharton/ CIBC
Wood Gundy
10% 1995 End-User
11% 12% Survey:
6% Frequency
0% With Which a
Alter the Alter the Actively “Market View
Timing of Size of Take Impacts FX
Hedges Hedges Positions Derivatives
Copyright ©2001 Ian H. Giddy [Link] Financial RiskTransactions
Management -42
 Sources of Corporate
Financial Risk
Uncertain Markets

Uncertain Mistaken
Risk!
Exposures Views

Wrong Risk Measurement Methods

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -46
 Monitoring and Control
Uncertain Markets

• Monitoring implies
performance measurement
Uncertain Mistaken
Risk!
• Performance measurement Exposures Views

is the science of attribution

• Performance measurement Wrong methods
requires a benchmark
Corporate Risk Management
• Surprises require
reassessment and
response Define Measure Manage Monitor

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -47

 Evaluate Management Reporting and
Risk Management Monitoring Process

Senior
Management

Management reporting and

Independent Risk focused performance
Management/ measurement are necessary
Internal Audit to identify problems with the
current risk management
strategies
Limits &
Benchmarks

Exposure Financial Product

Information Information
Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -48
 Summary: Corporate Market Risk
Management is a Process

Corporate Risk Management

Define Measure Manage Monitor

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -49

 Ian Giddy

Ian H. Giddy
NYU Stern School of Business
44 West 4th Street, New York, NY 10012
Tel 212-998-0332; Fax 212-995-4233
[Link]@[Link]
[Link]

Copyright ©2001 Ian H. Giddy [Link] Financial Risk Management -53