Treasury Control and
Performance Evaluation
Prof Ian Giddy
New York University
A Corporate Foreign Exchange
Application
TRANSACTIONS
FORECASTS FROM
BUSINESS UNITS
Copyright ©1996 Ian H. Giddy
CONSOLIDATION
NET POSITIONS,
BY CURRENCY
AND MATURITY
VOLATILITY AND
CORRELATION
FORECASTS
VALUE
AT
RISK
Management, Markets and Linkages 3
The VaR Management Cycle
FIRM'S INT'L
BUSINESS
HEDGING
TRANSACTIONS
RISK
MANAGEMENT
DECISIONS
BOOKED &
ANTICIPATED
TRANSACTIONS
SCHEDULE OF
FX FLOWS
This process can be undertaken on a
monthly cycle basis, as the institution
revises its estimates of future business
and as new data on volatilities and
correlations are acquired.
PORTFOLIO
ANALYSIS OF
FX EXPOSURE
CORRELATION
DATA
Copyright ©1996 Ian H. Giddy
REPORTING
SYSTEM
MEASUREMENT
OF FX RISK BY
CURRENCY
NET
EXPOSURES
IN FOREIGN
CURRENCIES
VOLATILITY
DATA
Management, Markets and Linkages 4
The VaR Management Cycle
FIRM'S INT'L
BUSINESS
HEDGING
TRANSACTIONS
RISK
MANAGEMENT
DECISIONS
BOOKED &
ANTICIPATED
TRANSACTIONS
SCHEDULE OF
FX FLOWS
MEASUREMENT
OF FX RISK BY
CURRENCY
NET
EXPOSURES
IN FOREIGN
CURRENCIES
PERFORMANCE
EVALUATION
PORTFOLIO
ANALYSIS OF
FX EXPOSURE
CORRELATION
DATA
Copyright ©1996 Ian H. Giddy
REPORTING
SYSTEM
VOLATILITY
DATA
Management, Markets and Linkages 5
Why Measure Performance of Treasury?
Performance evaluation: “the
science of attribution”
 Example: Why did this taxi take
so long?

The
traffic; the driver; my lousy
instructions?
How much should I tip this taxi
driver?
 Would I use this taxi company
again?

Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 6
Why Measure Performance of Treasury?
Like banks, treasurers face market
risks, and must manage them
 Unlike banks, exposures cannot be
known with precision - so there’s no
such thing as “fully hedged”
 Hedging is a dynamic process
 Making money is not enough - must be
evaluated relative to cost and risk and
capital allocated.

Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 7
Baltic Benchmarking
Nokia: “performance measurement
(selective vs. full hedge) is encouraged but
not required”
 Ericsson: “it is something we should look at”
 Borealis: “no satisfactory relationship
between risk and return”
 Kværner’s qvestions:

Am
I making money and if so, why?
How does my profit or loss relate to
the risks that have been taken?
Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 8
What Do We Want to Measure?
Return performance (did we outperform
some benchmark measure?)
 Risk reduction

Hedged
positions?
Reduced earnings volatility (historical)?
Reduced Value at Risk (anticipated)?

Reporting, disclosure and problem
identification (have we improved our risk
measurement system?)
Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 9
Risk and Return
RETURN
RISK
Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 10
Kinds of Trading Risk for
Performance Measurement
Corporate Risk Hedging vs Bank-withinthe-Company
 What Risks?

Position
Risk
Basis Risk
Liquidity Risk
Counterparty Risk
Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 11
Choosing the Right Yardstick: Return
Profitability - wrong!
 Compare with “best practice”
companies - wrong.
 Compare with “forward rates”
 Evaluate return relative to risk

Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 12
Unbiased Forward Rate Theory
EXCHANGE
RATE
Probability
distribution
of actual
exchange rate
Spot
Forward
Actual
Today
Copyright ©1996 Ian H. Giddy
TIME
In three
months
Management, Markets and Linkages 13
Performance Evaluation: Example
FARMCO: PERFORMANCE EVALUATION
Oct. 1
Predicted
Expected
1995
exposures Spot
Forward Return
Volatility Hedge
CAD
-200758 1.3374 1.3405
1.0%
1.79
150000
DEM
22365 1.4288 1.4165
2.5%
3.82
0
JPY
-15688 100.39
97.83
2.0%
3.71
10000
Portfolio expected profit
1,180
Portfolio total VaR
9,337
Portfolio diversified VaR
5,210
Expected gain, relative to risk (VaR)
23%
April 1
Actual
Actual Actual
Actual
1996
Exposures
Spot
Return
Volatility Hedge
CAD
-220400
1.3736
2.5%
2.1
150000
DEM
24000
1.3901
1.9%
4.2
0
JPY
-11500
97.00
-0.8%
5.3
10000
Portfolio actual profit
1,278
Portfolio total VaR
11,251
Portfolio diversified VaR
5,913
Actual gain, relative to actual risk (VaR)
22%
Adjusted gain, based on predicted exposures
Adjusted gain, relative to actual risk (VaR)
Adjusted gain, relative to ex-ante risk (VaR)
Copyright ©1996 Ian H. Giddy
788
13.3%
15.13%
Management, Markets and Linkages 15
Performance Evaluation: Example
FARMCO: PERFORMANCE EVALUATION
Oct. 1
Predicted
Expected
1995
exposures Spot
Forward Return
Volatility Hedge
CAD
-200758 1.3374 1.3405
1.0%
1.79
150000
DEM
22365 1.4288 1.4165
2.5%
3.82
0
JPY
-15688 100.39
97.83
2.0%
3.71
10000
Portfolio expected profit
1,180
Portfolio total VaR
9,337
Portfolio diversified VaR
5,210
Expected gain, relative to risk (VaR)
23%
April 1
Actual
Actual Actual
Actual
1996
Exposures
Spot
Return
Volatility Hedge
CAD
-220400
1.3736
2.5%
2.1
150000
DEM
24000
1.3901
1.9%
4.2
0
JPY
-11500
97.00
-0.8%
5.3
10000
Portfolio actual profit
1,278
Portfolio total VaR
11,251
Portfolio diversified VaR
5,913
Actual gain, relative to actual risk (VaR)
22%
Adjusted gain, based on predicted exposures
Adjusted gain, relative to actual risk (VaR)
Adjusted gain, relative to ex-ante risk (VaR)
Copyright ©1996 Ian H. Giddy
788
13.3%
15.13%
Management, Markets and Linkages 16
What Happened?
FARMCO: PERFORMANCE EVALUATION
Oct. 1
Predicted
Expected
1995
exposures Spot
Forward Return
Volatility Hedge
CAD
-200758 1.3374 1.3405
1.0%
1.79
150000
DEM
22365 1.4288 1.4165
2.5%
3.82
0
JPY
-15688 100.39
97.83
2.0%
3.71
10000
Portfolio expected profit
1,180
Portfolio total VaR
9,337
Portfolio diversified VaR
5,210
Expected gain, relative to risk (VaR)
23%
April 1
Actual
Actual Actual
Actual
1996
Exposures
Spot
Return
Volatility Hedge
CAD
-220400
1.3736
2.5%
2.1
150000
DEM
24000
1.3901
1.9%
4.2
0
JPY
-11500
97.00
-0.8%
5.3
10000
Portfolio actual profit
1,278
Portfolio total VaR
11,251
Portfolio diversified VaR
5,913
Actual gain, relative to actual risk (VaR)
22%
Adjusted gain, based on predicted exposures
Adjusted gain, relative to actual risk (VaR)
Adjusted gain, relative to ex-ante risk (VaR)
Copyright ©1996 Ian H. Giddy
788
13.3%
15.13%
Management, Markets and Linkages 17
How Am I Doing?
FARMCO: PERFORMANCE EVALUATION
Oct. 1
Predicted
Expected
1995
exposures Spot
Forward Return
Volatility Hedge
CAD
-200758 1.3374 1.3405
1.0%
1.79
150000
DEM
22365 1.4288 1.4165
2.5%
3.82
0
JPY
-15688 100.39
97.83
2.0%
3.71
10000
Portfolio expected profit
1,180
Portfolio total VaR
9,337
Portfolio diversified VaR
5,210
Expected gain, relative to risk (VaR)
23%
April 1
Actual
Actual Actual
Actual
1996
Exposures
Spot
Return
Volatility Hedge
CAD
-220400
1.3736
2.5%
2.1
150000
DEM
24000
1.3901
1.9%
4.2
0
JPY
-11500
97.00
-0.8%
5.3
10000
Portfolio actual profit
1,278
Portfolio total VaR
11,251
Portfolio diversified VaR
5,913
Actual gain, relative to actual risk (VaR)
22%
Adjusted gain, based on predicted exposures
Adjusted gain, relative to actual risk (VaR)
Adjusted gain, relative to ex-ante risk (VaR)
Copyright ©1996 Ian H. Giddy
788
13.3%
15.13%
Management, Markets and Linkages 18
Key Measures of Performance
Return: (Actual return - forward premium)
 Return relative to risk
(the “Sharpe” ratio):

Historical
volatility of returns
Historical volatility of position value
Ex ante Value at Risk
RETURN
RISK
Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 19
Using a VaR Measure for Trading-Portfolio
Performance Evaluation

The Sharpe ratio.
(actual return relative to actual risk)

The risk ratio.
(actual return relative to prospective risk)

The efficiency ratio.
(actual risk relative to prospective risk)
Use risk-return performance measures to
evaluate individual trader performance.
Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 20
Performance Measurement: Roadmap

Map exposures
FINANCIAL SIDE
EXPOSURES

Known

Anticipated
OPERATIONAL SIDE

Map risks
MARKET PRICES
RISK MEASUREMENT

VaR

Worst-case scenario, etc.
MARKET VOL & CORR.

RISK MANAGEMENT

Hedging

Investment or trading
Manage risks
Measure performance
 Take actions to improve
performance

Copyright ©1996 Ian H. Giddy
PERFORMANCE MEASUREMENT

Relative return

Relative risk.


INCENTIVES
ALLOCATION OF RESOURCES.
Management, Markets and Linkages 21
Sola Chemical
President
Sola USA
Managers,
Asia
Europe
Latin America
Area Treasurer
Copyright ©1996 Ian H. Giddy
Area Controller
Finance Committee
Area Tax Attorney
Controller
Treasurer
Assistant Controller Intl
Assistant Treasurer Intl
Tax Attorney
Management, Markets and Linkages 22
Sola Chemical
Tax planning - cerntralize?
 FX exposure - Paper loss? Centralize to
net exposures?
 Transfer pricing and performance
evaluation - 2nd set of books?
 Sourcing funds - cheap local
opportunities lost?
 Other considerations?

President
Sola USA
Managers,
Asia
Europe
Latin America
Area Treasurer
Area Controller
Finance Committee
Area Tax Attorney
Controller
Treasurer
Tax Attorney
Assistant Controller Intl Assistant Treasurer Intl
Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 23
Treasury Performance Measurement:
Conclusion
Performance evaluation: “the
science of attribution”
 Why did we make/lose money?

The
market; the FX manager; my
lousy instructions?
How much should I tip this FX
manager?
 Would I use this method again?
 How good is my performance
measurement system?

Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 24
Summary of “Value at Risk” Reporting
“At close of business each day tell me what the
market risks are across all businesses and
locations.”
Dennis Weatherstone, JP Morgan
Logical steps:
Economic-value
accounting (need market
prices or models)
Market-price based performance measurement
Volatilities and correlations of market prices
Management of risk
Optimization of hedging
Copyright ©1996 Ian H. Giddy
Management, Markets and Linkages 26
THE END