Giddy/SIM
Financial Risk Management/1
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
Copyright ©2001 Ian H. Giddy
Measure
giddy.org
Manage
Monitor
Financial Risk Management -5
Giddy/SIM
Financial Risk Management/2
Financial Risk Management
Why does it matter?
l Why and when should we hedge?
l What should we hedge? How should we
gauge exposure?
l
l
Financial risk management must be tied
to the company’s business
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -6
The Case For Hedging
Company has special information
l Company has special market access
l Secure cash for investment opportunities
l 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.
l
Copyright ©2001 Ian H. Giddy
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Financial Risk Management -7
Giddy/SIM
Financial Risk Management/3
Optimal Capital Structure
VALUE OF THE FIRM
HEDGING CAN
REDUCE COSTS
OF FINANCIAL
DISTRESS
ALL-EQUITY VALUE
DEBT
RATIO
giddy.org
Copyright ©2001 Ian H. Giddy
Financial Risk Management -8
Hedging, Valuation, Taxes and
Financial Distress
Negative
net worth
Positive
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
Copyright ©2001 Ian H. Giddy
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Financial Risk Management -9
Giddy/SIM
Financial Risk Management/4
When Should Firms Hedge?
Business risk
Financial risk
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -10
Which Firms Should Hedge?
Characteristics of firms for which financial stress is
especially costly:
l Firms with:
u Products
that require after-sale servicing
u Products whose quality is difficult to determine in
advance
u Products with high switching costs
u Products that rely on third-party servicing
l
And firms that have:
u High-growth
opportunities
u Intangible assets like firm-specific human capital
u Large excess tax deductions
Copyright ©2001 Ian H. Giddy
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Financial Risk Management -11
Giddy/SIM
Financial Risk Management/5
What Exposure Should Firms Hedge?
l Currency
risk
uTransactions
uTranslation
exposure
uEconomic exposure
uInterest
Rate Risk
uCommodity Price Risk
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -12
Measuring Market Exposure
Defining corporate exposure:
“How will my company’s value be
affected by market price fluctuations?”
l Types of exposure
l
uTransactions
uBalance
sheet/portfolio
uEconomic
l
A risk management framework
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -13
Giddy/SIM
Financial Risk Management/6
How Effective is My Company’s Risk
Management?
Warning Signs:
l
l
l
l
Don’t measure risk
No linkage of risk to
value
No effort to anticipate
Lack of business risk
policy
Copyright ©2001 Ian H. Giddy
l
l
l
l
Fragmented effort
Narrow focus
Poor risk
communications
Lack of an
integrated risk
assessment
framework
giddy.org
Financial Risk Management -14
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
Association Guidelines, or
accumulated knowledge of
appropriate practices
Define
Measure Manage Monitor
• Assess centralization issues
related to financial risk
management and treasury
design
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -15
Giddy/SIM
Financial Risk Management/7
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,
Transaction Exposure, and
Economic Exposure
Absolute Rate Risk,
Convexity, Basis or
Correlation Risk
Price Risk, Basis or
Correlation Risk
• Short-term liquidity portfolio
• Procurement
• Investment portfolio
• Inventory
• Intracompany versus third
party exposure
• Capital markets borrowing
• Sales elasticity
• Cross currency exposure
• Leasing portfolio
• Long-term versus short-term
exposure
• Competitive exposures
Currency
Copyright ©2001 Ian H. Giddy
Interest Rate
giddy.org
Commodity
Financial Risk Management -16
Market Risks: Definitions
Three Views of
Market Price Risk:
l Transactions
l Balance
Sheet/Portfolio
l Economic risk.
Copyright ©2001 Ian H. Giddy
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Financial Risk Management -17
Giddy/SIM
Financial Risk Management/8
Market Risks: Definitions
Three Views of
Market Price Risk:
l Transactions
Transactions
Transactions
Exposure
Exposure
l Balance
Sheet/Portfolio
l Economic risk.
Portfolio
Portfolio
Exposure
Exposure
Copyright ©2001 Ian H. Giddy
giddy.org
Economic
Economic
Exposure
Exposure
Financial Risk Management -18
Transactions
Transactions
Exposure
Exposure
Transactions Exposure
Portfolio
Portfolio
Exposure
Exposure
l
Economic
Economic
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
uExample:
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.
uThis kind of exposure is readily hedgable
using forwards, futures or debt
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -19
Giddy/SIM
Financial Risk Management/9
But Transactions Exposure
Can be Misleading...
Transactions
Transactions
Exposure
Exposure
Portfolio
Portfolio
Exposure
Exposure
Economic
Economic
Exposure
Exposure
Austin Computer purchases notebook
computers in Taiwan for sale in the US.
l Austin must pay in NT$.
l Should it hedge its anticipated
payments for 1996?
l
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -20
Transactions
Transactions
Exposure
Exposure
Austin Computer
Portfolio
Portfolio
Exposure
Exposure
Economic
Economic
Exposure
Exposure
NT$
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -21
Giddy/SIM
Financial Risk Management/10
Transactions
Transactions
Exposure
Exposure
Interest Rate Risk:
Portfolio
Portfolio
Portfolio
Exposure
Exposure
Economic
Economic
Exposure
Exposure
Portfolio risk: interest rate fluctuations
can affect the value of a bond
investment portfolio
l Bond price fluctuations will affect the
balance sheet
l Can be hedged, using duration as a
risk/sensitivity measurement tool
l Can be hedged with futures, bond
options, and swaps.
l
giddy.org
Copyright ©2001 Ian H. Giddy
Financial Risk Management -22
Transactions
Transactions
Exposure
Exposure
Pepsico Pension
Portfolio
Portfolio
Exposure
Exposure
Assets (each $10m):
u 1-year
E$ deposit
u 5-year, 6% T-note
D=4.6
u 10-year Strip
l What
Economic
Economic
Exposure
Exposure
Pension liabilities:
u $10m
3 years
u $10m 5 years
u $10m 7 years
is Pepsico pension fund’s risk?
uDuration
of the assets (+ve)
uDuration of the liabilities (-ve)
uNet duration is the risk to be hedged!
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -23
Giddy/SIM
Financial Risk Management/11
Transactions
Transactions
Exposure
Exposure
Value at Risk: SantosBank
Portfolio
Portfolio
Exposure
Exposure
SANTOSBANK
POSITIONS
INSTRUMENT
30 day
90 day
180 day
1 yr
2 yr
3 yr
4 yr
5 yr
7 yr
9 yr
10 yr
15 yr
Economic
Economic
Exposure
Exposure
Asset and liability
positions for a
Brazilian bank’s
New York branch.
What risk does it
face?
($1,250,000)
($100,000)
$450,000
$120,000
$120,000
$120,000
$1,120,000
$0
$0
$0
($420,000)
$0
NET
$160,000
TOTAL
$3,700,000
giddy.org
Copyright ©2001 Ian H. Giddy
Financial Risk Management -24
Transactions
Transactions
Exposure
Exposure
BIS: Minimize Value at Risk
Portfolio
Portfolio
Exposure
Exposure
INSTRUMENT
30 day
90 day
180 day
1 yr
2 yr
3 yr
4 yr
5 yr
7 yr
9 yr
10 yr
15 yr
NET
TOTAL
Economic
Economic
Exposure
Exposure
SANTOSBANK
POSITIONS
($1,250,000)
($100,000)
$450,000
$120,000
$120,000
$120,000
$1,120,000
$0
$0
$0
+
($420,000)
$0
$160,000
$3,700,000
=
Value-at-Risk
Value-at-Risk
Mean
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -25
Giddy/SIM
Financial Risk Management/12
Transactions
Transactions
Exposure
Exposure
Market Price Risk: Economic
Portfolio
Portfolio
Exposure
Exposure
Economic
Economic
Exposure
Exposure
l Economic
risk arises from the real
business risk of the company,
insofar as it is tied to market
interest rates, FX, commodity
prices
l It affects the shareholder value, but
may be difficult to quantify
l Hedging may require tailored
solutions
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -26
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?
l Answer: Business exposure is to lead &
zinc prices (mine shutdown in Oct 96
because of low zinc prices)
l Hedge with digital option linking cost
of funds to lead & zinc prices
l
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -27
Giddy/SIM
Financial Risk Management/13
Transactions
Transactions
Exposure
Exposure
Market Price Risks: Summary
Portfolio
Portfolio
Exposure
Exposure
Economic
Economic
Exposure
Exposure
Three Views of
Market Price Risk:
l Transactions
- lock in
forward rate
l Portfolios
uAvoid
duration mismatching
l Minimize Value at Risk
l Economic
risk - business
sensitivity to market prices.
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -28
“Most Important” Objective In
Using Derivatives To Hedge
Market Value of the Firm
8%
Volatility in Cashflow
49%
Volatility in Earnings
42%
Copyright ©2001 Ian H. Giddy
Balance Sheet Accounts
1%
giddy.org
CIBC Wood Gundy/Wharton
1995 End-User Survey
“Most Important” Objective In
Using Derivatives To Hedge
Financial Risk Management -29
Giddy/SIM
Financial Risk Management/14
Next Step: Analyze Current
Exposure Measurement Techniques
Precision
Precisionof
ofthe
thedata
data
Risk Information
Sources:
Time horizon of the
projections
•Current trade flow data
Frequency of
reporting
•Portfolio system reports
•Accounting information
•Budgeted trade flow data
•Pricing practices
Quantification Adequacy
giddy.org
Copyright ©2001 Ian H. Giddy
Financial Risk Management -30
Corporate Exposure
Information Sources
Current trade flow data
Portfolio system reports
Exposure
Database
Hard
Accounting information
Budgeted trade flow data
Soft
Copyright ©2001 Ian H. Giddy
Economic exposure
estimates
giddy.org
Financial Risk Management -32
Giddy/SIM
Financial Risk Management/15
Exposure Database: Example
Exposure
Database
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -33
From Data to Analysis
Exposure
Database
Exposure Measurement
System
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -34
Giddy/SIM
Financial Risk Management/16
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.
l 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
l
n
Portfolio Risk Simulation
n
n
n
n
nn
n
n
nn n
n
nn
n
($000)
RISK
n
n
n nn
n nn AUD
n nn BEF
n nn CAD
n nn DKK
n nn FFR
n nn DEM
n nn ITL
n nn JPY
n nn NLG
n nn ESBnnn SEK nn
n CHF
1 Mo
n
n
3
n Mo
nn
nn
n
6 Mo
n
nn
nn
nn - 200
15
nn
nn
RiskMetricsª
nnGBP
n
22
20
n
- 30
n
25
n
12 Mo
n
n
n
XEU
nn
USD
nn
nn
nn
nn
Total
37
nn
160
nn
nn
- 50
-5
20
- 105
- 105
n
nn
2 Yr
n
nn
0
n
nn
3 Yr
n
nn
0
n
nn
4 Yr
n
nn
n
nn
5 Yr
n
nn
7 Yr
n
nn
9 Yr
n
nn
n
nn
n
nn
n
nn
10 Yr
n
nn
n
nn
15 Yr
n
nn
0
0
0
0
0
0
n
nn
20 Yr
n
nn
0
n
nn
30 Yr
n
nn
0
n
nn
0
Equity
n
n
nn
n
n
nn n
nn
n
n
n
n nn
nn
n
n
nn
USD Base. Vols. & correls. as of May 04, 1995.
n
n
n
nnn
nn n
n
n nn- 196.1
nn
n
Spot
n
Net
nn
Int.
n
nn
nn 59
nn
n
n
n nn- 196.1
nn
n
22
n
- 29
23
nn 502
nn
nn 82
nn
262
22
5
n
nn
n
n
- 29
n
139
n
nn
54
nn
nn
nn
nn
- 145
23
- 122
400
740
n
n
Implied
nnn
FX
nn
n
n
n
n
nn
Eq.
nnn
nn
n
nFx
nn
n
divers.
n nn
nnn
nNet
nn
giddy.org
Copyright ©2001 Ian H. Giddy
n
n nn 5,048nn
n
n
n nn - 200 nn
n nn 5,350nn
nn 4265
nn - 347
nn 4181
1383
n
1820
-6
- 83
1383
1876
nn
n
n
n
8516
nn
nn
nn
- 451
400
8805
Financial Risk Management -35
Exposure Report: Example
Portfolio Risk Simulation
RiskMetricsª
USD Base. Vols. & correls. as of May 04, 1995.
Gov't Bonds Zero Cashflow
AUD
1 Mo
3 Mo
6 Mo
12 Mo
2 Yr
3 Yr
4 Yr
5 Yr
7 Yr
9 Yr
10 Yr
15 Yr
BEF
CAD
-200
DKK
FFR
15
20
25
DEM
22
ITL
JPY
-30
NLG
ESB
SEK
CHF
GBP
XEU
USD
160
-5
-105
20 Yr
30 Yr
0
0
Equity
0
Implied
FX
($000)
- 196.1
- 196.1
59
23
82
22
-29
502
262
5
139
5,048
4265
1383
1820
Spot
Net
RISK
Total
37
- 50
20
- 105
0
0
0
0
0
0
0
0
Int.
22
-29
54
-145
23
-122
400
740
Eq.
Fx
divers.
Net
Copyright ©2001 Ian H. Giddy
-200
-347
-6
-83
5,350
4181
1383
1876
giddy.org
8516
-451
400
8805
Financial Risk Management -36
Giddy/SIM
Financial Risk Management/17
Market Risk Measurement
Where are we now? Where do we need to be?
Option
Sensitivity
Measures
Volumetric Duration/
PVof01
• Notional
Amounts
Copyright ©2001 Ian H. Giddy
Simulations
Value
at
Risk
• Non-linear risk • Limited market
• Distribution of
• Linear risk
measures
scenarios that
market moves and
measures
could include
portfolio values
• Swap/ bond • Delta, gamma,
vega, theta, rho market
• Includes market
equivalents
• No aggregation of correlations
correlations
risk measures • Reprice portfolio • Reprice portfolio
across asset
• Parallel and non- • Aggregate risk
classes or
measures within
parallel curve
confidence interval
instruments
shifts
• Aggregate portfolio
risk per scenario
giddy.org
Financial Risk Management -37
An Overview of Corporate VAR
Business 1
Business 2
Business 3
Transactional
Database
Portfolio
Database
Projected Revenues
Projected Operating Costs
Base rates/
Currency market
conditions
•
•
Volatilities
Correlations
Model 1
Interest Rates
Model 2
Mean
Equities
Model 3
Commodities
Historical rates/
Discrete scenarios
Estimates of Cash Flow Distribution
Model 4
Impact on
Earnings
Currencies
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -38
Giddy/SIM
Financial Risk Management/18
Analyze Exposure Management
Activities
•Multicurrency borrowing/
investing, currency of invoice, &
commercially-based hedging
techniques
Investigate
opportunities for
natural offsets
•Financial instruments such as
forwards, futures, swaps and
options
Evaluate alternative
hedging techniques
•Expected and out-of-pocket costs,
benefits and risks of potential
strategies; competitors’ actions
Cost/benefit analysis
•Accordance with overall corporate
policy and acceptable from an
accounting and regulatory
standpoint, if applicable
Strategic alignment
giddy.org
Copyright ©2001 Ian H. Giddy
Financial Risk Management -39
Corporate Exposure Management:
Match Tools to Risks
Current trade flow data
Hard
Inflexible,
committed
Portfolio system reports
Accounting information
Budgeted trade flow data
Soft
Copyright ©2001 Ian H. Giddy
Economic exposure
estimates
giddy.org
Flexible,
optional
Financial Risk Management -40
Giddy/SIM
Financial Risk Management/19
Most-Used Instruments
Hedge Identifiable Exposure
70%
60%
50%
40%
30%
20%
Foreign Exchange
Interest Rates
10%
Commodity
0%
Forwards
Futures Swaps
OTC
Exchange
Options
Struct.
Options
Der.
Type of Transaction
Equity
Hybrid
Debt
1995 CIBC/Wharton End- User Survey
giddy.org
Copyright ©2001 Ian H. Giddy
Source of
Exposure
Financial Risk Management -41
Market Views Impact
Corporate FX Hedging Decisions
80%
Sometimes
70%
Frequently
60%
50%
61%
40%
48%
30%
33%
20%
10%
11%
12%
Alter the
Timing of
Hedges
Alter the
Size of
Hedges
0%
Copyright ©2001 Ian H. Giddy
giddy.org
Wharton/ CIBC
Wood Gundy
1995 End-User
Survey:
6%
Frequency With
Which a “Market
View Impacts FX
Actively
Derivatives
Take
Transactions
Positions
Financial Risk Management -42
Giddy/SIM
Financial Risk Management/20
Sources of Corporate
Financial Risk
Uncertain Markets
Uncertain
Exposures
Mistaken
Views
Risk!
Wrong Risk Measurement Methods
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -46
Monitoring and Control
Uncertain Markets
• Monitoring implies
performance measurement
Uncertain
Exposures
• Performance measurement
is the science of attribution
• Performance measurement
requires a benchmark
Mistaken
Views
Wrong methods
Corporate Risk Management
• Surprises require
reassessment and
response
Copyright ©2001 Ian H. Giddy
Risk!
Define
giddy.org
Measure Manage Monitor
Financial Risk Management -47
Giddy/SIM
Financial Risk Management/21
Evaluate Management Reporting and
Risk Management Monitoring Process
Senior
Management
Management reporting and
focused performance
measurement are necessary
to identify problems with the
current risk management
strategies
Independent Risk
Management/
Internal Audit
Limits &
Benchmarks
Exposure
Information
Financial Product
Information
giddy.org
Copyright ©2001 Ian H. Giddy
Financial Risk Management -48
Summary: Corporate Market Risk
Management is a Process
Corporate Risk Management
Define
Copyright ©2001 Ian H. Giddy
Measure
giddy.org
Manage
Monitor
Financial Risk Management -49
Giddy/SIM
Financial Risk Management/22
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
ian.giddy@nyu.edu
http://www.giddy.org
Copyright ©2001 Ian H. Giddy
giddy.org
Financial Risk Management -53