Treasury 2000 NYU/GTA Financial Risk Management Prof. Ian Giddy New York University Risk Management is a Process Corporate Risk Management Define Copyright ©1999 Ian H. Giddy Measure Manage Monitor 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 Copyright ©1999 Ian H. Giddy Financial Risk Management -6 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 ©1999 Ian H. Giddy Financial Risk Management -7 Optimal Capital Structure VALUE OF THE FIRM HEDGING CAN REDUCE COSTS OF FINANCIAL DISTRESS ALL-EQUITY VALUE DEBT RATIO Copyright ©1999 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 ©1999 Ian H. Giddy Financial Risk Management -9 When Should Firms Hedge? Business risk Financial risk Copyright ©1999 Ian H. Giddy Financial Risk Management -10 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 ©1999 Ian H. Giddy Financial Risk Management -11 What Exposure Should Firms Hedge? Currency risk Transactions Translation exposure Economic exposure Interest Rate Risk Commodity Price Risk Copyright ©1999 Ian H. Giddy 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 Balance sheet/portfolio Economic A risk management framework Copyright ©1999 Ian H. Giddy Financial Risk Management -13 How Effective is My Company’s Risk Management? Warning Signs: Don’t measure risk No linkage of risk to value No effort to anticipate Lack of business risk policy Copyright ©1999 Ian H. Giddy Fragmented effort Narrow focus Poor risk communications Lack of an integrated risk assessment framework Financial Risk Management -14 Formalize Risk Management Policy and Control Framework • Develop an outline of a policy statement, or recommend improvements to existing document • Benchmark controls versus best practice using the Group of Thirty Recommendations, Treasury Management Association Guidelines, or accumulated knowledge of appropriate practices Corporate Risk Management Define Measure Manage Monitor • Assess centralization issues related to financial risk management and treasury design Copyright ©1999 Ian H. Giddy Financial Risk Management -15 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 • Long-term versus short-term exposure • Intracompany versus third party exposure • Cross currency exposure Absolute Rate Risk, Convexity, Basis or Correlation Risk Price Risk, Basis or Correlation Risk • Short-term liquidity portfolio • Procurement • Investment portfolio • Inventory • Capital markets borrowing • Sales elasticity • Leasing portfolio • Competitive exposures Currency Copyright ©1999 Ian H. Giddy Interest Rate Commodity Financial Risk Management -16 Market Risks: Definitions Three Views of Market Price Risk: Transactions Balance Sheet/Portfolio Economic risk. Copyright ©1999 Ian H. Giddy Financial Risk Management -17 Market Risks: Definitions Three Views of Market Price Risk: Transactions Transactions Exposure Balance Sheet/Portfolio Economic risk. Portfolio Exposure Copyright ©1999 Ian H. Giddy Economic Exposure Financial Risk Management -18 Transactions Exposure Transactions Exposure Portfolio Exposure Economic 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 Copyright ©1999 Ian H. Giddy Financial Risk Management -19 But Transactions Exposure Can be Misleading... Transactions Exposure Portfolio Exposure Economic Exposure Austin Computer purchases notebook computers in Taiwan for sale in the US. Austin must pay in NT$. Should it hedge its anticipated payments for 1996? Copyright ©1999 Ian H. Giddy Financial Risk Management -20 Transactions Exposure Austin Computer Portfolio Exposure Economic Exposure NT$ Copyright ©1999 Ian H. Giddy Financial Risk Management -21 Interest Rate Risk: Portfolio Transactions Exposure Portfolio Exposure Economic 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 ©1999 Ian H. Giddy Financial Risk Management -22 Transactions Exposure Pepsico Pension Portfolio Exposure Assets (each $10m): 1-year E$ deposit 5-year, 6% T-note D=4.6 10-year Strip What Economic Exposure Pension liabilities: $10m 3 years $10m 5 years $10m 7 years 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 ©1999 Ian H. Giddy Financial Risk Management -23 Transactions Exposure Value at Risk: SantosBank Portfolio 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 Copyright ©1999 Ian H. Giddy SANTOSBANK POSITIONS ($1,250,000) ($100,000) $450,000 $120,000 $120,000 $120,000 $1,120,000 $0 $0 Economic Exposure Asset and liability positions for a Brazilian bank’s New York branch. What risk does it face? $0 ($420,000) $0 $160,000 $3,700,000 Financial Risk Management -24 Transactions Exposure BIS: Minimize Value at Risk Portfolio 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 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 Mean Copyright ©1999 Ian H. Giddy Financial Risk Management -25 Transactions Exposure Market Price Risk: Economic Portfolio Exposure Economic 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 Copyright ©1999 Ian H. Giddy 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? 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 ©1999 Ian H. Giddy Financial Risk Management -27 Transactions Exposure Market Price Risks: Summary Portfolio Exposure Economic 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 ©1999 Ian H. Giddy 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 ©1999 Ian H. Giddy Balance Sheet Accounts 1% CIBC Wood Gundy/Wharton 1995 End-User Survey “Most Important” Objective In Using Derivatives To Hedge Financial Risk Management -29 Next Step: Analyze Current Exposure Measurement Techniques Precision of the data Risk Information Sources: Time horizon of the projections •Current trade flow data •Portfolio system reports •Accounting information Frequency of reporting •Budgeted trade flow data •Pricing practices Copyright ©1999 Ian H. Giddy Quantification Adequacy 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 ©1999 Ian H. Giddy Economic exposure estimates Financial Risk Management -32 Exposure Database: Example Exposure Database Copyright ©1999 Ian H. Giddy Financial Risk Management -33 From Data to Analysis Exposure Database Exposure Measurement System Copyright ©1999 Ian H. Giddy Financial Risk Management -34 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 1Mo 3Mo 6Mo ($000) RISK RiskMetricsª USD Base. Vols. & correls. as of May 04, 1995. AUD BEF CAD DKK FFR DEM -200 15 ITL JPY NLG ESB SEK CHF 22 20 GBP -30 25 12 Mo XEU USD Total 37 160 - 50 -5 20 -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 Equity 0 0 FX - 196.1 - 196.1 Spot Net Int. 59 22 -29 23 502 54 -145 23 82 22 -29 262 5 139 4265 1383 1820 8516 -347 -6 -83 -451 4181 1383 1876 -122 400 740 Eq. Implied Copyright ©1999 Ian H. Giddy Fx divers. Net 5,048 -200 5,350 400 8805 Financial Risk Management -35 Exposure Report: Example Copyright ©1999 Ian H. Giddy Financial Risk Management -36 Market Risk Measurement Where are we now? Where do we need to be? Volumetric Duration/ PVof01 • Notional Amounts Copyright ©1999 Ian H. Giddy Option Sensitivity Measures Simulations • Non-linear risk • Limited market • Linear risk measures scenarios that measures could include • Swap/ bond • Delta, gamma, vega, theta, rho market equivalents • No aggregation of correlations risk measures • Reprice portfolio across asset • Parallel and nonclasses or parallel curve instruments shifts • Aggregate portfolio risk per scenario Value at Risk • Distribution of market moves and portfolio values • Includes market correlations • Reprice portfolio • Aggregate risk measures within confidence interval 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 ©1999 Ian H. Giddy Financial Risk Management -38 Analyze Exposure Management Activities Investigate opportunities for natural offsets Evaluate alternative hedging techniques Cost/benefit analysis Strategic alignment Copyright ©1999 Ian H. Giddy •Multicurrency borrowing/ investing, currency of invoice, & commercially-based hedging techniques •Financial instruments such as forwards, futures, swaps and options •Expected and out-of-pocket costs, benefits and risks of potential strategies; competitors’ actions •Accordance with overall corporate policy and acceptable from an accounting and regulatory standpoint, if applicable 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 ©1999 Ian H. Giddy Economic exposure estimates Flexible, optional Financial Risk Management -40 Most-Used Instruments Hedge Identifiable Exposure 70% 60% 50% 40% 30% 20% Foreign Exchange Interest Rates 10% Commodity 0% Forwards Futures Swaps OTC Exchange Struct. Options Options Type of Transaction Der. Copyright ©1999 Ian H. Giddy Source of Exposure Equity Hybrid Debt 1995 CIBC/Wharton End-User Survey 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 ©1999 Ian H. Giddy 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 Sources of Corporate Financial Risk Uncertain Markets Risk! Copyright ©1999 Ian H. Giddy Financial Risk Management -43 Sources of Corporate Financial Risk Uncertain Markets Risk! Copyright ©1999 Ian H. Giddy Mistaken Views Financial Risk Management -44 Sources of Corporate Financial Risk Uncertain Markets Uncertain Exposures Copyright ©1999 Ian H. Giddy Risk! Mistaken Views Financial Risk Management -45 Sources of Corporate Financial Risk Uncertain Markets Uncertain Exposures Risk! Mistaken Views Wrong Risk Measurement Methods Copyright ©1999 Ian H. Giddy 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 • Surprises require reassessment and response Copyright ©1999 Ian H. Giddy Mistaken Views Risk! Wrong methods Corporate Risk Management Define Measure Manage Monitor Financial Risk Management -47 Evaluate Management Reporting and Risk Management Monitoring Process Senior Management Independent Risk Management/ Internal Audit Limits & Benchmarks Exposure Information Copyright ©1999 Ian H. Giddy Management reporting and focused performance measurement are necessary to identify problems with the current risk management strategies Financial Product Information Financial Risk Management -48 Summary: Corporate Market Risk Management is a Process Corporate Risk Management Define Copyright ©1999 Ian H. Giddy Measure Manage Monitor 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 ian.giddy@nyu.edu http://www.giddy.org Copyright ©1999 Ian H. Giddy Financial Risk Management -53