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Case Study: China Aviation Oil (Singapore) Limited
Financial Markets (Indian Institute of Management Ranchi)
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Financial Markets
Assignment – II
Case Study: China Aviation Oil (Singapore) Limited
Presented To: Prof. Dr. Kamran Quddus
Prepared &Presented By: Group - IV
Sl. No. Name
Roll No.
01.
Pratik Gaurav
X016-20
02.
Priyam Mitra
X017-20
03.
Rahul Sharan
X018-20
04.
Rana Singh
X019-20
05.
Sachin Yadav
X020-20
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Introduction:
China Aviation Oil Corp Ltd. was an overseas controlling subsidiary of the China Aviation Oil
Holding Company. On May 26th 1993, China aviation oil (Singapore) Pte limited was
incorporated as a private company limited by shares. The company became a public
company on November 6th 2001 and changed its name from China aviation oil(Singapore)
Pte limited to China Aviation Oil (Singapore) Corporation limited (CAO). In the same year,
CAO was listed on Singapore stock exchange with 25% of share capital as public float. The
core business of the CAO was to procure jet fuel from the overseas markets for distributing
the same to different airline companies which are functioning in China through its parent
company, a subsidiary and an associate. Apart from the core business, the company also
provides value added services to its airline customers. These services included assurance of
prompt delivery of commodities, offer of lower shipping, storage and transportation costs,
offer of low fuel cost through bulk purchases, provision of market information, advice for
inventory planning, risk management and assurance of consistent supply of high quality
fuels. Besides jet fuel procurement, the company was also engaged in the trading of
petroleum products such as jet fuel, gasoil, fuel oil, crude oil, and plastics. However, on June
27th 1998, China Aviation Oil (Singapore) Corporation limited got an approval from
Singapore Ministry of Trade as an approved oil trader(AOT). As a result, China Aviation Oil
got a monopoly of supply of jet fuel to nearly all the Chinese airports. However,
approximately 95% of its business was coming from the three largest airports i.e. Beijing,
Shanghai and Guangzhou.
Despite its growth, the company was facing serious problem since 2003 due to volatility of
oil prices. An increase in the price of oil might cause the company’s customers to defer their
purchases of oil and other oil products in anticipation that Oil price might come down later.
But it never happened because since 2003, Oil price showed only a steep upward trend.
Thus this volatility had an effect on the company and its profits. In these circumstances,
since the beginning of 2003 CAOC started swap and future trades to reduce the impact of
the volatility of oil prices and optimize its procurement requirements. Moreover, on behalf
of client airline companies CAOC started back-to-back option trading49 since the beginning
of 2003. By the end of 2003, the company began its speculative trading in fuel options by
writing call options and holding put options.
Oil Derivatives: The Failure of China Aviation Oil’s Speculative Intent
China Aviation Oil (Singapore) Corporation lost $550 million in speculative trading, making it
one of the biggest business scandals in Asia. The jet fuel provider's losses effectively wiped
out its market value of $549 million and the stock, which remained suspended on the
Singapore Exchange (SGX), was virtually worthless, causing much anger among its 7,000
investors. Moreover, CAO’s state-owned parent company in Beijing, China Aviation Oil
Holding Co. (CAOHC) raised S$196 million ($120 million) by reducing its stake in CAO from
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75% to 60%. The investors alleged that CAO and CAOHC breached insider trading laws for
failing to disclose the trading losses at the time of the share sale. Singapore Exchange
ordered CAO to allow Price Waterhouse Coopers to investigate the company’s internal
control and risk management policies and look into the circumstances leading to the losses.
On investigation, it was revealed that CAO and CAOHC allegedly failed to disclose the bad
investments made by them as required by SGX. A Singapore court found China Aviation Oil's
Chief Executive, Mr. Chen Jiulin, guilty of failing to notify SGX of CAO’s losses, conspiring to
cheat, making false and misleading statements, breaching his duties and inside trading. Mr.
Chen was fined $208,000 and was imprisoned for 51 months.
Background:
Chinese oil Market and China Aviation Oil
Oil was first discovered in the U.S. in 1859. At the beginning of the 20th century, oil catered
to only 4% of the world’s energy requirements. However, oil became, in the later part of
20th century, the most important source of energy. As a result, production of oil on a larger
scale, took place by the oil producing nations. During 2008, Saudi Arabia, Russia, USA, Iran,
Mexico, China, Canada and Norway are the largest oil producing countries (Chart I). In the
future, the Middle East and Russia were expected to provide an increasing share in world oil
production. In 2007, the world demand for oil reached 85.7 million barrels per day (mbpd),
which was one percent higher, compared to 84.9 million barrels per day (mbpd) consumed
in 2006. The IEA forecasted that oil demand would increase by nearly 10 million barrels per
day (mbpd) to 94.8 million barrels per day (mbpd) by 2015. Demand for OPEC oil was
forecasted to increase from current 31 million barrels per day (mbpd) to 38.8 million barrels
per day (mbpd) by 2015. The major oil consuming nations were USA, China, Japan, Russia,
Germany, India, South Korea, Canada, Brazil and Saudi Arabia where consumption in USA is
the highest. However, the US consumption had remained static over the past four years.
Compared to 2006, 70% of additional demand for oil in 2007 was accounted from China and
India. China had increased its petroleum consumption by 5.5 percent in 2007 up from 7.3
million barrels per day in 2006 to 7.7 million barrels per day.
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Chart I
TOP OIL PRODUCERS
(Listed by Barrels-per-Day)
Saudi Arabia
Russia
United States of America
Iran
11,100,000
9,677,000
8,322,000
4,150,000
Mexico
3,784,000
China
3,710,000
Canada
3,092,000
Norway
2,978,000
Venezuela
2,802,000
Iraq
2,000,000
United Kingdom
1,861,000
Libya
1,720,000
Brazil
1,590,000
Indonesia
1,070,000
India
834,600
Argentina
801,700
Egypt
688,100
Australia
572,400
Syria
390,000
Thailand
310,900
Italy
164,800
Germany
141,700
Japan
125,000
Ukraine
90,400
France
73,180
Pakistan
68,220
Turkey
45,460
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Prior to 1993, China was the net oil exporter (Chart II). But since 1993, china’s oil
consumption was increasing at a rate of 7.5% per year. Growth in the Chinese oil
consumption had accelerated mainly because of the increased number of private
automobiles. This increased consumption made China a net oil importer. However,
some market analysts expected that China would become the world's second largest oil
consuming country after the United States and third oil importer after United States and
Japan.
Chart II
In recent years, China had imported its crude oil from Angola, Saudi Arabia, Iran, Russia,
Oman, Equatorial Guinea and Yemen (Chart III). In 2006, Africa (primarily Angola) had
supplied approximately 40% of China's oil imports. To reduce its dependence for oil on the
Middle East, China turned towards Angola, an African province. However, as a whole, the
Middle East, still, remained the largest oil supplier to China. The industry analysts have
predicted that in 2007, China's crude-oil output would grow by less than 2%, while the
country's demand for both crude and oil products would rise by 6%. As a result, China’s
dependency on imported oil would increase further in the year 2007. Moreover, China had
been making aggressive efforts to diversify its sources of oil imports in order to reduce the
unsystematic risks.
Oil price had traditionally been denominated in US dollars and to some extent in Euros.
During 2007, the crude oil spot price averaged $72 per barrel which is more than triple
the average price recorded in 2002 (Chart IV). Towards the end of 2007, the price of
crude oil reached $100 per barrel and, in May 2008 it touched $120 per barrel. Thus the
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price movements of oil became extremely volatile. As a result, businesses operating on
oil and natural gas became susceptible to price risks. Factors that might affect the short
term oil prices were geo-political instability, refinery constraints, hurricanes, oil supply
bottlenecks, and low inventories. However, some of the reasons for the upward trend in
oil price might be the disequilibrium in oil demand and supply, depreciation of dollar
and increased speculation on the price of the oil.
Chart III
Chart IV
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An oil producing company could manage its exploration risk by way of diversification
strategy – simultaneous digging into multiple exploration sites and taking insurance against
the probability of failure in finding an active well. As against this, the volume risk could be
covered by maintaining inventories or acquiring productive assets. On the other hand,
derivatives were more appropriate for managing the price risk of a firm.
China Aviation Oil’s Debacle in Oil Derivative Trading:
Between March 2003 and second quarter of 2003, CAO took a bullish view of oil prices.
Taking this view, the company sold put options. As oil price was on increasing trend, the
option buyer did not exercise their option. As a result, the company earned option
premium from such sales. It was a successful strategy for CAO and enabled the company to
earn a good revenue.
Starting from third quarter of 2003, CAO took a bearish view on the oil markets. To play
for its hunch, CAO bought put options and sold call options on oil. However, the
exercise date of option was the first quarter 2004. CAO also sold some call options with
extendible futures in order to increase the premium income. Unfortunately, this did not
materialise as the oil prices were on upward trend for the whole year. At that time, oil
futures contracts reached in high number on New York Mercantile Exchange (NYMEX).
As a result, CAO’s put options expired and the company lost option premiums only. But
in respect of the call options, it was “in the money” from the point of view of the option
holder. Hence, the holders of the option contracts exercised their options. The
cumulative effect of the increase in oil prices and exercise of the options resulted in a
sharp drop in the mark-to-market (MTM) values of the options held by CAO.
As the direction of the market was moving against the position taken, CAO restructured
their option strategy in March 2004 by repurchasing the call options, which was sold
earlier to close out the loss-making options. To finance the loss created by the
restructure, the CAO sold longer dated call options with higher strike prices with higher
volumes which stretched out to fourth quarter of 2005. Furthermore, CAO did not feel
the need to show, the losses made by its loss-making options in its financial statements.
In fact, it had restructured the financial statements so as to achieve a zero net cash flow
position. It believed that there was no extra risk in selling those options. According to
CAO, the premiums generated from the sale of new options would equalize the losses
made in the earlier loss-making options. However, the rising trend in the oil prices still
continued. As a result, with the greater risks under the new options, the drop in MTM
margin was far more higher compared to the earlier losses made. Hence, Singapore
Stock Exchange made margin calls against CAO in May 2004.
In June 2004, second restructuring was undertaken by CAO with the same objective of
achieving zero net
cash flow. However, this time, the losses that needed to be equalized were higher. As oil
prices continued to rise, massive margin calls were made. For example, one of the trades
involved in sale of call options by CAO on 300,000 barrels of Brent crude at a strike price of
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$34.25 with an expiry date of October 29th 2004. The option was exercised at $49.34,
causing a loss of around $4.5 million for the company. The company did not record the said
loss in its mark-to-market account. Furthermore, the premiums received were brought into
revenue account and the traders felt that the company was earning money. These
unrealized losses accumulated until the margin calls became too large to manage.
Third restructuring was done in October 2004, which only worsened the problem61. During
2004, the New York Mercantile Exchange (NYMEX) oil futures contracts had reached a
record high of $55.17 per barrel on October 26th when compared to $34 per barrel at the
beginning of the year (Chart V). On the other hand, the company’s mark-to-market losses
went out of control and the company faced problems with margin call payments, prompting
several counterparties to close out trades unilaterally. Around that time, China Aviation Oil
Holding Company realised $108 million from sale of 15% stake in CAO on October 20th
200462. The stake sale proceeds were loaned to CAO to cover its margin payments.
However, by November 29th 2004, the company was unable to meet margin calls on its
derivatives positions and forced to book a loss of $550 million.
Chart V
.
Arising out of this action, SGX suspended trading in CAO’s Singapore Aviation Oil’s shares
and as a result, the price of these shares dropped to below S$1.00 per share as compared to
S$1.70 per share recorded earlier. In February 2006, former Finance Chief of CAO, Peter Lim,
was jailed for two years and fined S$150,000 for making false and misleading statements
about the trading losses65. The High Court of Singapore ordered China Aviation Oil to
submit a reorganization plan after its loss of $550 million due to betting on oil prices66.
In November 2001 CAO stated in its original prospectus when it came to market, that once
mark-to-market losses from a single trader reach $200,000, the risk controller would alert
the Chief Executive, Risk Management Committee and other traders. Each trader was given
a stop-loss limit of $500,000 and if losses breach this limit, then all open positions must be
closed without waiting for the approval of the Chief Executive. These disclosure failures and
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failure to implement the good corporate governance procedures created serious problems
for CAO. Mr. David Gerald, the President and Chief Executive of the Securities Investors
Association of Singapore (SIAS) stated, “Singapore had not seen a corporate governance
disaster of this magnitude”. This brought into focus, internal and risk management controls
and corporate governance practices of the listed companies in Singapore. At the direction of
Singapore exchange limited, special auditors, Price Waterhouse Coopers were appointed by
CAO in November 2004 with an objective to provide recommendations and advice to the
Board of Directors to improve the corporate governance system and suggest good
management structure for the company. The Monetary Authority of Singapore was
expected to review the corporate governance rules when the investigations were completed
by the auditors.
Singapore government had introduced reforms to bolster governance, but the collapse of
China Aviation Oil, reflected the gap between theory and practice. Policies and procedures
without enforcement were no use to the company or government. On the other hand,
segregation of duties between employees in smaller organizations comes at a high cost
because volumes may not justify the same. Again, it was the responsibility of the senior
management and the board to make sure that the books of accounts were kept well as per
rules.
A trader decides his option strategy considering his risk tolerance. However, the strategy
depends on the trader’s expectation about the future direction of the market. The success
of a particular option strategy depends on the success of the perception of the future by the
trader.
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Assignment Questions:
Q1. What was the company's trading strategy?
CAO’s trading strategy changed from hedging risks in 2002 to speculation with bullish
strategy (bought calls and sold puts)in Q1 2003, which proved to be an accurate prediction.
However, CAO then took a bearish view of the trend in oil prices in the fourth quarter of
2003, and began to sell calls and buy puts, with the result that it was in a short position at
the end of the quarter. As the assumption was that oil prices would fall, it was further
assumed that the counterparties would not extend the options, and these would therefore
lapse to the benefit of the company.
Q2. How did the company form its view?
The objective behind the speculative options trading was to generate profits from the
premium. However, the risk of such trades was not properly assessed by CAO; in fact CAO
did not have the proper risk management framework to handle such complex options. As
per PWC report, “The fact that the company commenced speculative options trading in the
first quarter of 2003, without putting in place a proper risk management environment,
raises questions on the strength of its corporate governance”
Originally, CAO took a bullish view of the jet fuel market. Predicting that the market price of
jet fuel would continue its upward trend, CAO took a long position in the market, and sold
puts and bought calls. CAO predicted correctly. Favorable market trends resulted in CAO
exercising the call options at expiry. Written put options expired worthless. CAO gained
from the exercise of call options and from the premium of put options; this strategy yielded
enormous profit for CAO in the first three quarters of 2003.
By the end of 2003, CAO revised its strategy to a bearish stance; CAO predicted that the
trend of jet fuel prices would reverse and the prices of jet fuel would go down. The CEO
signed contracts with several banks, buying put options and selling call options. But that was
a wager the company lost. The prices soared well above the strike price of the call and CAO
faced a large deficit.
Q3. What were the determinants of company's escalating bet?
The Special Auditor from PwC assigned by SGX discovered that the company used the wrong
MTM valuation method by ignoring the time value, which lead to the misestimation of oil
price and the wrong speculation strategy. While CAO had the chance to remedy the mistake
by comparing the pricing with counterparties’ but the company met the margin calls
without protest until it lost the financial capacity to do so at the end of September 2004.
The company developed fast and became monopoly in the market since 2000. In order to
bolster its profile as well as boost investor’s confidence and generate more profit, the
company was willing to take high risk. In year 2003, companypredicted another Gulf War.
The company wanted to take advantage of the war so that higher risk is acceptable as fuel is
a critical resource during wars.Also the lack of risk management knowledge of the CEO,
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insufficient management environment within the company and the inefficient external
audit, further accelerated the mishandling of situation.
Q4. Could there have been a safer trading strategy?
The case provides example in which: regulatory compliance, profit reporting and bending
laws took precedence over the risk management and proper accounting reporting. There
was a lack of oversight and inadequate knowledge of the market. Following things would
have been adopted for safer trading:
Better control and enhancement of risk management was necessary in order to avoid
unprecedented and unexpected losses.
An independent risk management department which would have been provided on the
ground vigilance and responsiveness to ensure risk management policies are adhered to.
Building early-warning systems, which encouraged employees to find potential risks and
report them to management.
The financial reporting must follow the best practice with frequent and detailed disclosures.
One should not indulge in a market one does not have good knowledge of.
Q5. What was the motivation behind the trading strategy?
➢ The main motivation behind such trading strategy was to gain enormous
profit.
➢ They want to grow fast and targeting to become monopoly in the market
since 2000.
➢ They were ready to take high risk in order to bolster its profile as well as
boost investor's confidence.
➢ They might also want to take the advantage of the factor that fuel is a critical
resource during the war and hence they can take higher risk.
➢ The company commenced speculative options trading in the first quarter,
without putting in place a proper risk management environment.
➢ They took a bullish view of the jet fuel market. Predicting that the market
price of jet fuel would continue its upward trend, they took a long position in
the market. They predicted correctly. This strategy yielded enormous profit
for them in the first three quarters.
Hence, they got motivated for opting such strategies.
Q6. How do you use hedging strategies? What kind of hedging strategies can
be used in this case?
➢ As we know that hedging strategies are used to reduced the exposure to risk in
event that an asset in the portfolio is subject to a sudden price decline.
➢ If we do it properly it will reduce the uncertainty and limit losses without
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significantly reducing the potential rate of return.
➢ We can use put option. A put option on a stock or index is a classic hedging
instrument. With a put option, we can sell a stock at a specified price within a
given time frame
➢ We can determine the option pricing by downside risk. By this we can understand
how much we stand to lose as the result of a decline. If a security is capable of
significant price movements on a daily basis, then an option on that security that
expires weeks, months or years in the future would be considered risky and thus
would be more expensive. Conversely, if a security is relatively stable on a daily
basis, there is less downside risk, and the option will be less expensive.
➢ We should consider expiration date and strike price. The strike price is the price at
which the option can be exercised. Options with higher strike prices are more
expensive because the seller is taking on more risk. However, options with higher
strike prices provide more price protection for the purchaser.
➢ We can also use long term put option or option with longest expiry date.
In this case, they started its option trading initially to hedge its jet fuel risk thorough
derivatives of futures and swaps. However, after some time they started trading in
speculative derivative options.
➢ They should first understand the risks to be hedged.
➢ Should have Evaluate the severity and timing of downside risks properly,
➢ Should have consider the financial instruments available and costs of certain
instruments to determine the most cost-effective way to hedge.
Q7. When do you need to hedge? Is it necessary to hedge?
➢ We need to hedge because it is a risk management strategy employed to
offset losses in investments by taking an opposite position in a related
asset.
➢ In other words it locks the profit.
➢ Enables traders to survive hard market periods. It limits losses to a great
extent
➢ As it facilitates investors to invest in various asset classes, therefore,
increases liquidity. It also helps in saving time as the long-term trader is
not required to monitor or adjust his portfolio with daily market volatility
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➢ It offers a flexible price mechanism as it requires lower margin outlay
➢ It gives the trader protection against commodity price changes, inflation,
currency exchange rate changes, interest rate changes, etc. on successful
hedging
➢ In hedging using option provides traders an opportunity to practice
complex options trading strategies to maximize return
➢ It helps in increasing liquidity in financial markets.
Yes it is necessary to hedge. But it should be done properly. Hedging is always a
good idea but the individual investor has to determine what kind of hedging is
best. If it is not dot properly it may lead to huge loss. Risk and reward are often
proportional to one other, thus reducing risk means reducing profits. For most
short-term traders, example for a day trader, hedging is a difficult strategy to
follow. If the market is performing well or moving sidewise, then hedging offer
little benefits. Trading of options or futures often demand higher account
requirements like more capital or balance. Hedging is a precise trading strategy
and successful hedging requires good trading skills and experience.
Q8. How do you find the most cost-effective way to hedge? How do you
determine the cost of hedging?
Answer –
➢ Long term put options is the most cost-effective way to hedge. A six-month put
option is not always twice the price of a three-month put option. When purchasing
an option, the marginal cost of each additional month is lower than the last.
➢ We have to choose hedge that only pays off after a specified drawdown threshold
similar to an insurance contract with a large deductible.
➢ We can also use a hedge which includes a cap, with the result that the hedge pays
off only in a specified range.
➢ Holding cash is one way to reduce volatility and downside risk. The less a portfolio
has allocated to risky assets like equities, the less it can lose during a stock market
crash. The trade-off is that cash earns little to no return and loses buying power due
to inflation.
➢ Also we have to choose a hedge which provides insurance against losses for a fixed
percentage of each loss.
➢ Diversification is one of the most effective ways to hedge a portfolio over the long
term. By holding uncorrelated assets as well as stocks in a portfolio, overall volatility
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is reduced. Alternative assets typically lose less value during a bear market, so a
diversified portfolio will suffer lower average losses.
➢ We can use collar. It entails buying a put option and selling a call option. By selling a
call option, part of the cost of the put option is covered. The trade-off is that upside
will be capped. If the index rises above the call option strike price, the call option will
result in losses. These will be offset by gains in the portfolio.
➢ Put Spread- It consists of long and short put positions. If the spot price falls below
the lower strike, gains on the long put will be offset by losses on the short put.
➢ Fence – It is a combination of a collar and a put spread. This entails buying a put with
a strike price just below the current market level and selling both a put with a lower
strike price and a call with a much higher strike price. The result is a low-cost
structure that protects part of the downside while allowing for some upside.
➢ Covered all – It involves selling out of the money call options against a long equity
position. This doesn’t actually reduce downside risk, but the premium earned does
offset potential losses to an extent. This strategy is usually used on individual stocks.
If the stock price rises above the strike price, losses on the option position offset
gains on the equity position.
To determine the cost of hedging we have to find how much contracts we should sell. That
is the number of contracts required to hedge is found by dividing the amount of the asset to
be hedged by the dollar value of each contract.
NC = VA/VC
Where, NC = number of contracts for the hedge
VA = Value of the asset
VC = Value of each contract.
Hence, we hedge by selling NC numbers of contract.
Then we have to calculate profit and loss. If the net gain is zero, it means hedge has been
conducted successfully.
Question 9 : What should be the company's philosophy on financial risks?
When it Comes to financial risk CAO board of directors should assess and allocate the riskbearing capacity of a firm which in turn depends on the risk culture of the firm. The board
must state clearly the firms risk philosophy regarding financial risks. Once this is identified in
good or Bad , the firms senior management will be able to work out the organizations risk-
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bearing capacity and formulate the significant policies relating to the management and
control of financial risks. Even a financial-risk-averse firm will often find itself facing financial
risks which have resulted from core business deals. It may for example have to take out a
floating-interest rate loan to finance a project. Such a loan exposes it to the vagaries of
interest rates which may go up and down during the life of the loan. The firm thus faces
interest rate risk which it decides to hedge. A risk-averse organization will permit no
mismatch between the hedge and the transaction to be hedged in terms of interest rate
reset dates or termination dates; a finer point of detail that can only come from a clear
annunciation of the firms risk culture. But even if there was no mismatch in interest reset
and termination dates, there will still be some inherent risk in the hedge because the loan
will probably be hedged by a swap. Because the two instruments are similar but not
identical there will be basis risk which arises whenever there are imperfectly-matched
offsetting risk positions. Therefore even a risk-averse firm must establish a good risk control
system, because financial risks are part and parcel of todays corporate life.
Que 10: How can the supervisory boards can play a role in risk management particularly
when instruments such as derivatives can be highly complex?
Supervisory boards can play a role in risk management by establishing process to monitor
and control the hedging of transactions in a timely and accurate manner . Such written
Policies are reviewed annually by the Risk Management committee for the Managing
Director and Chief Executive Officer’s approval and endorsement by the Board of Directors.
The Group uses derivative financial instruments to reduce its exposure to market risk .
Enhanced Risk Management – Three Layer Control
CAO Board of Directors
Audit Committee
Internal Audit Division
Risk Management Committee
Head Of Division
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Within the Above the Framework . The Internal Control Supervision Structure comprises all
Appointed heads of Divisions , an Independent Risk management Committee and an internal
audit Division that all reports directly to the Board’s Audit Committee .
Q11. Who formulates the Firm's guidelines and policies on the use of Financial
instruments?
Senior managers (including executive members of the board) should formulate the major
policies and guidelines of an institution. The policies must cover how and when financial
instruments, particularly derivatives, may be used in the broadest terms; with procedures
sufficiently detailed to prevent inadvertent speculation. The Gibson Greetings and Procter &
Gamble experiences highlight the need for very comprehensive guidelines. These policies
must be drawn up in line with the institutions capital base, its broader business aims, its risk
culture and its overall ability to manage and control risk. Policy makers should also decide
whether the firm can pursue an aggressive hedging policy; i.e. hedging both anticipated and
existing transactions as well as allowing clearly mismatched hedges in order to reduce costs.
If the board condones an aggressive hedging strategy, then it must accept the dangers of
open risk positions inherent in such a strategy. To prevent an aggressive hedging strategy
from being used as a smokescreen for speculation, senior managers must set down all of the
circumstances under which such transactions are permitted. These policies and procedures
should also cover proprietary trading, including a list of people who are allowed to transact
proprietary trades. In end-user firms (non-financial institutions), senior managers should
designate the people who are allowed to trade financial instruments and the managers to
whom these risk takers are accountable. Such a list enables the board of directors to
pinpoint who is accountable for the financial risks of the company.
Q12. How can the board foster a risk management culture within the firm? How does the
board ensure the integrity of the risk management system?
The board must clearly allocate risk management responsibilities among various senior
managers to promote and ensure management accountability for risk control. Senior
managers must be made to realize that their jobs are on the line if there are major failures
in control. The board must insist that senior managers place control issues on a par with
other strategic business matters. Management accountability for internal controls can also
be encouraged through comprehensive annual assessments and public reporting on the
effectiveness of risk management systems (as well as by regulators, if the institution is
supervised.)On its part, the board must not be guilty of paying lip-service to the need for
good controls and taking no concrete action. Its unqualified commitment to installing and
maintaining a first-class control system must be reflected in the resources it makes available
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and its attitude to risk control personnel. The board must also ensure that appropriate risk
education continues throughout the firm. It must make the funds available for the necessary
hardware and software as well as the recruiting and retention of the right numbers of
people with the appropriate expertise, skill and experience. Equally important, senior
control personnel must have authority and clout with the board and senior management.
They must have access and direct lines of communication with senior management, if not
board members. They should not be seen and treated as second-class citizens just because
they are not direct revenue-earners.
•
Internal and external auditors play an important role in the risk management process
of a firm by risk auditing, i.e. auditing and testing the risk management process and
internal controls on a periodic basis. They must ensure that the systems are robust.
If they uncover weaknesses or if there have been significant changes in the product
line or market circumstances, then they must risk audit these internal systems more
frequently. They should evaluate the independence and overall effectiveness of the
risk management function (especially relating to measuring, reporting and limiting
risks) and confirm that all risk profile data is accurate. They must ensure that risk
controllers and risk takers are complying with established risk management policies,
and that proper documentation on the risk management process and internal
controls is in place. Internal auditors reports should be sent directly to senior
managers and the supervisory board, which on their part must study these reports
and, if necessary act upon them. The supervisory board should set up an audit
committee (comprised entirely of non-executive Directors) to ensure senior
managers do not override internal controls in their daily operations. This function of
compliance testing requires systematic identification, testing, and evaluation of
critical internal controls to determine whether established procedures are followed.
The committee must be able to refer to the firms internal and external auditors but
must also have access to outside experts. They should also encourage banks with
whom the firm has regular dealing contacts to inform senior management of any
large/unusual trades. Outsiders eyes are a good and free method of internal control.
Q13. Is there a separation of duties between those who generate financial risks and those
who manage and control these risks?
The implementation of strong and effective risk management and controls within a firm
promotes stability throughout the entire financial system. Specifically, internal risk
management controls provide four important functions:
•to protect the firm against market, credit, liquidity, operational, and legal risks;
• to protect the financial industry from systemic risk;
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• to protect the firm’s customers from large non-market related losses (e.g., firm failure,
misappropriation, fraud, etc.); and
• to protect the firm and its franchise from suffering adversely from reputational risk.
In our opinion, the process of measuring, monitoring, controlling and reporting risk
exposures should always be managed separately from those who generate the activities
that bring about the risk. However, it is up to the management to decide how this
segregation of duties is achieved. The management should determine whether the
companies scale and complexity of activities warrant a separate independent risk
management person or unit.
Firms need to establish a mechanism to ensure that they have internal accounting controls
and risk management controls. Managementneed to establish a mechanism to ensure that
the entities they regulate have internal accounting controls and risk management controls.
The supervisory mechanism need not prescribe specific and detailed controls, but rather
provide general guidance to firms.
Firms and management need to determine that controls are set and monitored at the senior
management level at a firm; responsibility for monitoring controls is clearly defined;
In a small or medium-sized outfit, this person could be a member of management who is
not directly involved in the day-to-day generation of risk or is not profit-responsible for such
activities. These independent managers or units should report exposures directly to senior
managers and the board.
Senior managers must clearly delineate responsibilities between front- (whoever assumes
financial risks for the organisation) and back-office (settlements and accounting) which
should always be manned and supervised separately. They must also ensure proper
reconciliation of front and back-office databases, for example by appointing a unit (person)
independent of the business to verify position data, profit and loss figures and individual
transaction details. This reconciliation should be carried out regularly with the frequency
depending on the volume of transactions. As a guide, organisations which actively use
financial instruments carry out reconciliations daily.
Q14. What type of financial instruments may the firm use? How are these financial
instruments valued? Is there a limit system in place?
In our opinion, all firms should have a list of approved financial instruments, including
derivatives. Each instrument must be clearly described together with an analysis of its
usefulness in relation to other activities and the firm’s financial condition, together with
proper reasons for its use. The continuum of financial instruments must be covered, and the
list should distinguish between non-derivative (cash instruments such as fixed-rate bonds),
plain vanilla derivatives (e.g. a currency swap or an outright call option on Nestle shares),
exotic products (often more complex options, e.g. a lookback option), hybrids (e.g. fixed-
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rate bonds with options embedded in them) and leveraged derivative products (a specific
type of derivative financial instrument containing a formula or multiplier, which for any
given change in market prices, could cause the change in the products fair value to be
several times the change in the value of a similar product without the formula or multiplier.)
A comprehensive list will prevent products inadvertently slipping through the net.Senior
managers must ensure that all the risks arising from these approved instruments can be
measured and controlled by the existing risk management system.
These valuations must necessarily be carried out independently of those who trade the
instruments. They must be checked or audited on a timely basis by someone who is
independent of the trading unit. Failure to do so has created losses in many companies. In
some cases, there may not be readily available market prices for products which have been
customised to the specific needs of the firm. Senior managers should plan for such
contingencies, making sure that quotations can be obtained from two other financial
institutions before the firm is allowed to buy the instrument, or that there are people inhouse able to value the product. The latter should be independent of the risk-takerwho
bought the product originally.
All firms must have a comprehensive risk limit system consistent with the firms philosophy,
effectiveness at managing risk as well as its capital position. Senior management must
construct an integrated institution-wide limits system in accordance with the risk philosophy
laid down by the board of directors. They must calculate the risk limits for each type of
position as well as each major risk category. The limit system should provide the capability
to allocate limits down to individual business units. Authorised limits in the form of
transaction type, term, currency and size allocated to individuals should be based upon their
expertise and experience. Limit exemptions (including the authorisation procedures before
such transactions are executed) must be clearly spelt out. Only senior managers should deal
with limit excesses, and requests to go beyond set limits can only be approved by
authorised personnel. All employees must be made aware of the penalties and disciplinary
action they face if risk limits are broken; on its part senior management must ensure that
these penalties are carried out to the letter. Limit breaches and their dispositions must be
reported to the executive board and periodically to the supervisory board who must also
check that senior management is ensuring compliance with the established disciplinary
rules.
In addition, senior managers may draw up stop/loss limits for each individual trading group
and possibly each individual trader. These limits set the maximum amount of loss the firm
would tolerate before liquidating a position.
The entire limits process must be reviewed regularly - individual, business and risk-category
limits, limit utilisation, procedures for limit exemptions and penalties for breaching limits.
Senior managers should bear in mind the average utilisation of limits as well as the
maximum when they review limits.
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Q15. What are the main sources of risks a company faces?
Risks are classified according to the source of uncertainty. There is a long list of sources of
uncertainty, so there is a correspondingly long list of risks. Relatively well-defined categories
of risk exist, but no standard risk classification system applies to all companies because risks
should be classified in a manner that helps managers make better decisions in the context
of their particular company and its environment. All companies face the risk of not being
able to operate profitably in a given competitive environment, typically because of a shift in
market conditions. For example, a company’s ability to grow and remain profitable may be
affected by changes in customer preferences, the evolution of the competitive landscape, or
product and technology developments. There are three risks to which companies in the
investment industry are typically exposed and that are discussed in this chapter:
■ Operational risk, which refers to the risk of losses from inadequate or failed people,
systems, and internal policies and procedures, as well as from external events that are
beyond the control of the company but that affect its operations. Examples of operational
risk include human errors, internal fraud, system malfunctions, technology failure, and
contractual disputes.
■ Compliance risk, which relates to the risk that a company fails to follow all applicable
rules, laws, and regulations and faces sanctions as a result.
■ Investment risk, which is the risk associated with investing that arises from the fluctuation
in the value of investments. Although it is an important risk for investment professionals, it
is less important for individuals involved in support activities, so it receives less coverage
than operational and compliance risks in this chapter.
A.
OPERATIONAL RISK:
Operational risk is the risk of losses from inadequate or failed people, systems, and
internal policies and procedures, as well as from external events that are beyond the
control of the company but that affect its operations.
i.
Managing People
Human failures range from unintentional errors to fraudulent activities. Many
companies are exposed to occupational fraud (sometimes called internal fraud or
employee fraud), which is when an employee abuses his or her position for personal
gain by misappropriating the company’s assets or resources.
ii.
Managing Systems
Companies rely heavily on information technology (IT) systems. Consequently,
technology has become an increasingly important source of operational risk.
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Automated processes can reduce the frequency and severity of operational errors,
but they are not infallible. Failures of IT and communication systems can paralyse
business operations or greatly reduce their efficiency, harming the company’s
profitability via lower revenues, higher costs, or a combination of both.
iii.
Complying with Internal Policies and Procedures
The structure of a company varies with size and business activities engaged in, but
there are features common to all companies. For instance, power and authority are
delegated and responsibilities are assigned within most companies. In smaller
entrepreneurial companies, such assignments may be communicated informally,
with employees understanding their individual roles and degrees of authority. In
larger and more complex companies, the roles and levels of authority will be
formally defined and the business processes mapped out in more detail, usually
embedded in corporate management systems. Policies and procedures should
explicitly set out the delegation of authority and define clear responsibilities and
accountability. These definitions form the basis for the monitoring of and control
over business processes and provide feedback mechanisms.
iv.
Managing the Environment
The type of environment in which a company operates can add layers of uncertainty
that need to be addressed.
a. Political Risk
Political risk is the risk that a change in the ruling political party of a country
will lead to changes in policies that can affect everything from monetary
policy (money supply, interest rates, and credit) and fiscal policy (taxation) to
investment incentives, public investments, and procurement.
b. Legal Risk
Legal risk is the risk that an external party will sue the company for breach of
contract or other violations. A company should consider how it identifies and
conforms to all legal commitments it has undertaken.
c. Settlement Risk
Settlement risk (or counterparty risk) is the risk that when settling a
transaction, a company performs one side of the deal, such as transferring a
security or money, but the counterparty does not complete its side of the
deal as agreed, often because it has declared bankruptcy. This risk is
sometimes also called Herstatt risk because of an incident in 1974 when the
German Herstatt Bank ceased operations after counterparties had honoured
their obligation to transfer Deutsche Marks to Herstatt, but before Herstatt
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honoured its obligation to transfer the equivalent amount in US dollars back
to these counterparties.
B. COMPLIANCE RISK
Compliance risk is the risk that a company fails to comply with all applicable rules,
laws, and regulations. The risk of non-compliance with laws and regulations is higher
than non-compliance with internal policies and procedures because sanctions can be
applied. These sanctions can affect both individuals and companies and may be
severe. Ensuring compliance with rules and regulations has often been viewed as a
rather mundane chore, but the rapidly changing regulatory environment has recently
brought compliance to the forefront of business priorities. Many people believe that
the trend toward less regulation contributed to the global financial crisis that began
in 2008. The trend has reversed with the re-imposition of greater regulation and
oversight. This increased legislation, in turn, has led to more compliance activities
and more compliance risk.
i.
Framework for Legal and Regulatory Compliance
Every company has to follow a set of rules, beginning with the statutory laws and
other regulations imposed by regulatory bodies. In addition, many investment firms
must follow guidelines from regulators, stock exchanges, and industry associations
that have been given powers to oversee members. Because of their importance in
the financial system, banks and insurance companies have historically been subject
to heavy regulation, with detailed rules and scrutiny from regulatory authorities.
ii.
Key Compliance Risks
Types of regulation and how to comply with them are outlined in the Regulation
chapter. Below are just a few examples of key compliance risks that have the
potential to inflict serious damage on investment firms and their employees.
a. Corruption
Corruption, which is defined as the abuse of power for private gain, has received
heightened attention because of tightened laws and regulations on bribery and
increased regulatory scrutiny, investigations, prosecutions, and fines. Some
national authorities may apply these laws extra-territorially, even to foreign
entities. Firms that operate through agents and other third parties should be
aware that their responsibility for preventing corruption extends to the actions
of these third parties. Ignoring the practices of third parties does not constitute a
defence in the event of a regulatory investigation.
b. Tax Reporting
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Compliance with tax regulations is complicated because the principles and rules
vary considerably by jurisdiction. Companies are continuously developing
financial and legal structures, often with the intention of minimising taxes
overall. Uncertainty exists in how tax authorities will apply their rules, which is
compounded by the fact that rules change regularly. A conservative approach is
to conform to tried-and-tested precedents. A more aggressive approach is to
seek to exploit loopholes in the tax code, low-tax jurisdictions (so-called offshore
tax havens), and other grey areas.
c. Insider Trading
There are laws that prohibit the trading of a security when in possession of
important confidential information pertaining to the security in question. Most
markets have recently tightened laws regulating insider trading. Another trend is
an increase in investigations of insider trading; some such investigations are even
relying on techniques similar to those used in investigations of organised crime
cases—including tapping telephones, using evidence already collected to make
peripheral suspects co-operate, and gradually closing in to catch the central
participants of the scheme. Companies must implement policies and procedures
to ensure that traders understand the laws and that nobody in the company will
be in the position to violate them. Investment firms that face a high risk of
insider trading, such as investment banks, have “control rooms” to monitor
information flowing between teams. They also have virtual walls or information
barriers to restrict and segregate information and to manage other conflicts of
interest.
d. Anti-Money-Laundering
Anti-money-laundering legislation is a set of rules to prevent money derived
from criminal activities from entering the financial system and acquiring the
appearance of being from legitimate sources. These rules require companies in
the financial services industry, including those in the investment industry, to
obtain sufficient original or certified documentation to perform a formal risk
assessment on each client and counterparty; the procedures of such an
assessment are called know-your-customer procedures.
C. INVESTMENT RISK
Risk is a critical element of investment decisions. Investors, for instance, buy equity
securities, commodities, or real estate. When they do, they are exposed to investment
risk—that is, the risk associated with investing. For example, investors may face losses if
the company in which they bought common shares loses value or goes bankrupt or if
commodity or real estate prices fall. Investment risk can take different forms depending
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on the company’s investments and operations. Companies in the investment industry
typically experience three broad types of investment risk:
i.
Market risk, which is the risk caused by changes in market conditions affecting
prices.
Market risk, which arises from price movements in financial markets, can be
classified into the risks associated with the underlying market instruments: equity
price risk, interest rate risk (for debt securities), foreign exchange rate risk, and
commodity price risk.
Many investment firms are in the business of assuming investment risks, and they
tend to tolerate market risks. But like any other company, they must align their risk
profiles with their risk tolerance. They often implement an approach called risk
budgeting to determine how risk should be allocated among different business units,
portfolios, or individuals. For example, an asset management firm may use the
following risk budgeting steps:
➢
➢
➢
➢
Quantify the amount of risk that can be taken by the firm,
Set risk budgets and limits for each asset class and/or investment manager,
Allocate assets in compliance with the risk budgets,
Monitor to ensure that risk budgets are respected,
Market risks that cannot be tolerated must be mitigated, and companies have
different alternatives available. One of them is to hedge unwanted risks by using
derivative instruments.
ii.
Credit risk, which is the risk for a lender that a borrower fails to honour a contract
and make timely payments of interest and principal.
When assessing the creditworthiness of borrowers, it is important to consider both
their ability and willingness to repay their debts. For example, after the fall in real
estate prices in 2008, many homeowners in the United States were left with
mortgage loan balances that exceeded the market value of the property. Some of
those borrowers still had the ability to keep paying their mortgage loans but decided
to default and let the bank take possession of the property. This potentially unethical
decision is rational from a purely financial perspective, apart from the worse credit
profile for future borrowing.
Lending to governments or state-owned companies creates another type of credit
risk. Sovereign risk is the risk that a government will not repay its debt because it
does not have either the ability or the willingness to do so. The unique aspect of
sovereign risk is that lenders have limited legal remedies available to compel the
borrower to repay or to be able to recover the assets themselves. A government can
also prevent borrowers in its country from repaying their debts to foreign
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investors—for example, by implementing currency controls to make it difficult or
impossible for money to leave the country
iii.
Liquidity risk, which is the risk that an asset or security cannot be bought or sold
quickly without a significant concession in price.
Liquidity refers to the ability to buy and sell quickly without incurring a loss. It is a
core concern for companies and is often neglected when sources of financing, such
as bank credit, are plentiful. But during the global financial crisis of 2008, an acute
shortage of liquidity in the financial systems in many countries led to failures. These
failures occurred because some companies were unable to maintain access to
sufficient money to finance their working capital (inventories and receivables from
customers net of payables from suppliers) and, therefore, to keep their companies
going.
Q16. How do you think the creditors voted? How would you have voted if you were a
creditor? What is the basis for your decision?
China Aviation Oil, collapsed with $550 million in derivatives losses, offered creditors a
sweetened repayment deal as it fends off legal efforts to replace its Beijing-appointed
managers.
The company offered to pay its 100 creditors roughly $275 million over five years, up from
the $211 million it offered to repay them over eight years in a plan issued earlier that year.
Many creditors rejected that plan, with two creditors filing lawsuits against the company.
In January, the company issued its first restructuring plan, offering to pay creditors $100
million immediately and pay $120 million over eight years. The offer also came with a
threat: if creditors failed to accept it or if they or shareholders sued, the parent company
would withdraw financial support for CAO Singapore, leaving the company worthless.While
individual investors held back from taking legal action in Singapore, lawyers in the United
States filed class-action lawsuits on behalf of several shareholders there. Another lawsuit
has been filed by Indonesian investors whose stake in a Singapore refining company China
Aviation had agreed to buy before its collapse.
In November, CAOHC voted against CAO’s plan to buy a 20.6% share in SPC during the
company’s EGM.
In our opinion, we would also have voted against CAO. The amount of information a
shareholder receives depends on the type of institution and the volume of financial
instruments in the firms portfolio. It is to say, shareholders of financial institutions have a
right to expect significantly more information on the firms financial risks than shareholders
of an industrial company. This is because running financial risks is an integral part of a
financial institutions operations, while it is generally a by-product of an industrial company’s
daily business.
At the very minimum, a company should keep shareholders informed about the types of
financial instruments used and their purposes. It must make a distinction between
instruments that are used for hedging and those that are not, as well as the relevant
accounting policies. It should disclose the notional principal of these instruments, their
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maturity, cash requirements, market value and credit risk. It should also tell shareholders
how the firm monitors the values of these instruments. Where possible, firms should also
disclose the firms market risks; if quantitative information is not possible then a qualitative
discussion should be included.
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