Giddy/SIM Financial Risk Management/1

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 Measure Manage Monitor
Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -5

Financial Risk Management
l Why does it matter?

l Why and when should we hedge?
l What should we hedge? How should we

gauge exposure?
l Financial risk management must be tied

to the company’s business
The Case For Hedging
l 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.
Optimal Capital Structure
VALUE OF THE FIRM
HEDGING CAN
REDUCE COSTS
OF FINANCIAL
DISTRESS
ALL-EQUITY VALUE
DEBT
RATIO
Hedging, Valuation, Taxes and

Financial Distress
Negative Positive
net worth net worth
Profile of return to creditors
+
-
Costs of bankruptcy to creditors
Distribution of net worth with

hedging
Distribution of net worth

without hedging (or with
greater exchange rate
volatility)
Net worth of the firm

When Should Firms Hedge?
Business risk
Financial risk
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
What Exposure Should Firms Hedge?
l Currency risk
uTransactions
uTranslation
exposure
uEconomic exposure
uInterest
Rate Risk
uCommodity Price Risk
Measuring Market Exposure
l Defining corporate exposure:

“How will my company’s value be
affected by market price fluctuations?”
l Types of exposure
uTransactions
uBalancesheet/portfolio
uEconomic
l A risk management framework

How Effective is My Company’s Risk

Management?
Warning Signs:
l Don’t measure risk l Fragmented effort

l No linkage of risk to l Narrow focus
value l Poor risk
l No effort to anticipate communications
l Lack of business risk l Lack of an
policy integrated risk
assessment
framework
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 Define Measure Manage Monitor
Association Guidelines, or
accumulated knowledge of
appropriate practices
• Assess centralization issues
related to financial risk
management and treasury
design

Identification and Definition of

Financial Exposures
Goal: To identify significant financial risk exposures and

prioritize them in a manner consistent with
management's desired risk profile.
Translation Exposure, Absolute Rate Risk, Price Risk, Basis or
Transaction Exposure, and Convexity, Basis or Correlation Risk
Economic Exposure Correlation Risk
• Long-term versus short-term • Short-term liquidity portfolio • Procurement

exposure
• Investment portfolio • Inventory
• Intracompany versus third
party exposure • Capital markets borrowing • Sales elasticity
• Cross currency exposure • Leasing portfolio
• Competitive exposures
Currency Interest Rate Commodity
Market Risks: Definitions
Three Views of
Market Price Risk:
l Transactions
l BalanceSheet/Portfolio
l Economic risk.

Market Risks: Definitions
Three Views of
Market Price Risk: Transactions
Transactions
l Transactions Exposure
Exposure
l BalanceSheet/Portfolio
l Economic risk.
Portfolio
Portfolio Economic
Economic
Exposure
Exposure Exposure
Exposure
Transactions
Transactions
Exposure
Exposure
Transactions Exposure
Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure
l 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

Transactions
Transactions
Exposure
But Transactions Exposure Exposure
Can be Misleading... Portfolio

Portfolio
Economic
Economic
Exposure Exposure
Exposure Exposure
l 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?
Transactions
Transactions
Exposure
Exposure
Austin Computer
Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure
NT$

Transactions
Transactions
Exposure
Interest Rate Risk: Exposure
Portfolio Portfolio
Portfolio
Economic
Economic
Exposure Exposure
Exposure Exposure
l 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.
Transactions
Transactions
Exposure
Exposure
Pepsico Pension
Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure
Assets (each $10m): Pension liabilities:

u 1-year E$ deposit u $10m 3 years
u 5-year, 6% T-note u $10m 5 years
D=4.6 u $10m 7 years
u 10-year Strip
l What is Pepsico pension fund’s risk?

uDuration of the assets (+ve)
uDuration of the liabilities (-ve)
uNet duration is the risk to be hedged!
Transactions
Transactions
Exposure
Exposure
Value at Risk: SantosBank

Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure
SANTOSBANK
INSTRUMENT POSITIONS Asset and liability
30 day ($1,250,000)
90 day ($100,000) positions for a
180 day
1 yr
$450,000
$120,000
Brazilian bank’s
2 yr $120,000 New York branch.
3 yr $120,000
4 yr $1,120,000 What risk does it
5 yr $0
7 yr $0 face?
9 yr $0
10 yr ($420,000)
15 yr $0
NET $160,000
TOTAL $3,700,000
Transactions
Transactions
Exposure
Exposure
BIS: Minimize Value at Risk

Portfolio Economic
Portfolio Economic
Exposure Exposure
Exposure Exposure
SANTOSBANK
INSTRUMENT POSITIONS
30 day ($1,250,000)
90 day ($100,000)
180 day $450,000
1 yr $120,000
+
2 yr $120,000
3 yr $120,000
4 yr $1,120,000
5 yr $0
7 yr $0
9 yr $0
10 yr ($420,000)
15 yr $0
NET $160,000
TOTAL $3,700,000
= Value-at-Risk
Value-at-Risk
Mean

Transactions
Transactions
Exposure
Exposure
Market Price Risk: Economic Portfolio Economic

Portfolio Economic
Exposure Exposure
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
Inmet Mining Corp.
l 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
Transactions
Transactions
Exposure
Exposure
Market Price Risks: Summary

Portfolio Economic
Portfolio Economic
Exposure Exposure
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.
“Most Important” Objective In

Using Derivatives To Hedge
Market Value of the Firm
8%
Volatility in Cashflow
Volatility in Earnings
49%
42%
CIBC Wood Gundy/Wharton

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

Exposure Measurement Techniques
Precision
Precisionof
ofthe
thedata
data
Risk Information
Sources: Time horizon of the
projections
•Current trade flow data
•Portfolio system reports Frequency of
reporting
•Accounting information
•Budgeted trade flow data
•Pricing practices Quantification Adequacy
Corporate Exposure
Information Sources
Current trade flow data
Exposure
Portfolio system reports
Database
Hard
Accounting information
Budgeted trade flow data
Soft Economic exposure

estimates

Exposure Database: Example
Exposure
Database
From Data to Analysis
Exposure
Database
Exposure Measurement
System

A Management-Friendly Report
l 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

n n
n Portfolio Risk Simulation
n nn RiskMetricsª
n nn USD Base. Vols. & correls. as of May 04, 1995.
n n n nn 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 nnGBP nn
XEU USD Total
n nn n
1 Mo n nn nn 15 22 n nn 37
n nn n n Mo
3 nn n nn - 200 nn 20 - 30 n n nn nn 160 - 50
n nn n
6 Mo nn 25 n n nn nn -5 20
n
n nn 12 Mo n n nn nn - 105 - 105
n nn 2 Yr n nn 0
n nn 3 Yr n nn 0
n
n nn 4 Yr n nn 0
($000)
n nn 5 Yr n nn 0
n nn 7 Yr n nn 0
RISK
n nn 9 Yr n nn 0
n nn 10 Yr n nn 0
n
n nn 15 Yr n nn 0
n nn 20 Yr n nn 0
n
n nn 30 Yr n nn 0
n Equity n nn 0
n n
nn
n nn n nnn
Implied n n nn- 196.1
nn nn 59 22 - 29 n n nn nn 54 - 145
n n nn nn FX n
Spot nn 23
n nn 23
n
n nnn n nn
Net n n nn- 196.1
nn nn 82 22 - 29 n nn - 122
n
nn n Int.
n nn n n nn 502 nn nn 262 5 139 n n nn nn 400 740
n
n nn Eq.
n nnn nFx
nn n n nn 5,048nn nn 4265 1383 1820 n nn 8516
n
n nn n n nn
divers. n n nn - 200 nn nn - 347 -6 - 83
n nn - 451
n nn 8805
n nnn nNet
nn n n nn 5,350nn nn 4181 1383 1876 n nn 400
Exposure Report: Example
Portfolio Risk Simulation RiskMetricsª

USD Base. Vols. & correls. as of May 04, 1995.
AUD BEF CAD DKK FFR DEM ITL JPY NLG ESB SEK CHF GBP XEU USD Total
1 Mo 15 22 37
3 Mo -200 20 -30 160 - 50
6 Mo 25 -5 20
Gov't Bonds Zero Cashflow
12 Mo -105 - 105
2 Yr 0
3 Yr 0
4 Yr 0
5 Yr 0
7 Yr 0
9 Yr 0
10 Yr 0
15 Yr 0
20 Yr 0
30 Yr 0
Equity 0
Implied - 196.1 59 22 -29 54 -145
FX Spot 23 23
Net - 196.1 82 22 -29 -122
Int. 502 262 5 139 400 740

($000)
Eq.
RISK
Fx 5,048 4265 1383 1820 8516

divers. -200 -347 -6 -83 -451
Net 5,350 4181 1383 1876 400 8805

Market Risk Measurement
Where are we now? Where do we need to be?
Option Value
Volumetric Duration/ Sensitivity Simulations at
PVof01 Measures Risk
• Notional • Linear risk • Non-linear risk • Limited market • Distribution of

Amounts measures measures scenarios that market moves and
• Swap/ bond • Delta, gamma, could include portfolio values
equivalents vega, theta, rho market • Includes market
• No aggregation of correlations correlations
risk measures • Reprice portfolio • Reprice portfolio
across asset • Parallel and non- • Aggregate risk
classes or parallel curve measures within
instruments shifts confidence interval
• Aggregate portfolio
risk per scenario
An Overview of Corporate VAR
Transactional
Business 1 Database
Portfolio
Business 2
Database
Business 3 Projected Revenues
Projected Operating Costs

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

Analyze Exposure Management

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

Cost/benefit analysis
benefits and risks of potential
strategies; competitors’ actions
Strategic alignment •Accordance with overall corporate

policy and acceptable from an
accounting and regulatory
standpoint, if applicable
Corporate Exposure Management:

Match Tools to Risks
Inflexible,
Current trade flow data committed
Hard
Portfolio system reports
Accounting information
Budgeted trade flow data
Flexible,
Economic exposure optional
estimates
Soft
Most-Used Instruments
Hedge Identifiable Exposure
70%
60%
50%
40%
30%
20% Foreign Exchange
10% Interest Rates
0% Commodity Source of
Forwards
Exposure
Futures Swaps Equity
OTC
Exchange
Options Struct.
Type of Transaction Options Der. Hybrid
Debt
1995 CIBC/Wharton End- User Survey
Market Views Impact

Corporate FX Hedging Decisions
80%
70% Sometimes
Frequently
60%
50%
40% 61%
48%
30%
33%
20%
Wharton/ CIBC
Wood Gundy
10% 1995 End-User
11% 12% Survey:
6% Frequency With
0% Which a “Market
Alter the Alter the Actively View Impacts FX
Timing of Size of Take Derivatives
Hedges Hedges Positions Transactions
Sources of Corporate
Financial Risk
Uncertain Markets
Uncertain Mistaken
Risk!
Exposures Views
Wrong Risk Measurement Methods

Monitoring and Control

Uncertain Markets
• Monitoring implies
performance measurement
Uncertain Mistaken
Exposures Risk! Views
• Performance measurement
is the science of attribution
• Performance measurement Wrong methods
requires a benchmark
• Surprises require
reassessment and
response Define Measure Manage Monitor

Evaluate Management Reporting and

Risk Management Monitoring Process
Senior
Management
Management reporting and

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

Information Information
Summary: Corporate Market Risk

Management is a Process
Define Measure Manage Monitor

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

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Giddy/SIM Financial Risk Management/1

Financial Risk Management

Prof. Ian Giddy

Risk Management is a Process

Corporate Risk Management

Define Measure Manage Monitor

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -5

Financial Risk Management

l Why does it matter?

l What should we hedge? How should we

l Financial risk management must be tied

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -6

The Case For Hedging

l Company has special information

l Secure cash for investment opportunities

l Reduce potential costs of financial

Optimal Capital Structure

VALUE OF THE FIRM

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -8

Hedging, Valuation, Taxes and

Profile of return to creditors

Distribution of net worth with

Distribution of net worth

Net worth of the firm

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -9

When Should Firms Hedge?

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -10

Which Firms Should Hedge?

Characteristics of firms for which financial stress is

u Products that require after-sale servicing

l And firms that have:

What Exposure Should Firms Hedge?

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -12

Measuring Market Exposure

l Defining corporate exposure:

l A risk management framework

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -13

How Effective is My Company’s Risk

l Don’t measure risk l Fragmented effort

Formalize Risk Management Policy and

• Develop an outline of a policy

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -15

Identification and Definition of

Goal: To identify significant financial risk exposures and

• Long-term versus short-term • Short-term liquidity portfolio • Procurement

Currency Interest Rate Commodity

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -16

Market Risks: Definitions

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -17

Market Risks: Definitions

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -18

l Transactions exposure results from

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -19

Can be Misleading... Portfolio

l Austin Computer purchases notebook

l Should it hedge its anticipated

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -20

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -21

l Portfolio risk: interest rate fluctuations

Copyright ©2001 Ian H. Giddy giddy.org Financial Risk Management -22

Assets (each $10m): Pension liabilities:

l What is Pepsico pension fund’s risk?

Value at Risk: SantosBank