International Risk Management

International Risk Management Yulia Y. Finogenova Course Structure Date Topic Tasks/ Cases 16 March RM & Company's value. Class task: “RM at VV company” 23 March Hedging strategies and Risk appetite. FX Hedging strategies Case 1. «Delta Beverage Group» 30 March Guest lecture. The role of insurance in a strategy of risk management. Yury Markin. AIG - 06 April Foreign exchange risks hedging Case 2. “RM at Apache” 13 April Managing interest rate risks Case 3. “Currency risks at AIFS” 20 April Financial risks assessment: Value at Risk (VaR) Case 4. “Barrick gold: eliminating the gold hedging strategy” 27 April Managing Commodity-Linked Costs Class discussions: Exchange rate risk on covenants 04 May Group Projects Defenses Assessment scheme Item for assessing Result Number of points Participation - 20 (8 classes * 2,5 points each) Class Task “RM at VV company” Written solution 4 Class Task “Currency exchange risk management” Written solution 4 Case 1. “Delta Beverage Group“ Case Report 9 Case 2. “GM Foreign exchange Strategies” Case Report 12 Case 3. “Currency risks at AIFS” Case Report 8 Case 4. “Barrick gold: eliminating the gold hedging strategy” Case Report 8 Examination Group Project 35 Total 100 Recommended Readings Best books  The Essentials of Risk Management: The Definitive Guide for the Non-risk Professional by Michel Crouhy, Dan Galai, Robert Mark, McGraw-Hill, 2006  Financial Risk Manager Handbook + Test Bank: FRM(r) Part I/Part II by Philippe Jorion, Wiley Finance, 2011  Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk by Steve L. Allen, Wiley Finance, 2003  Value at Risk, 3rd Ed.: The New Benchmark for Managing Financial Risk Hardcover by Philippe Jorion, McGraw-Hill, 2006 Recommended Readings Available in our library Scott E Harrington, Gregory R Niehaus, Risk Management and Insurance, 2-nd Edition, McGraw –Hill Publishing, 2004 Internet resource Value and Risk: Beyond Betas. Aswath Damodaran (http://pages.stern.nyu.edu/~adamodar/) Other sources: 1. Enterprise Risk Management: A Methodology for Achieving Strategic Objectives. Gregory Monahan. Wiley and SAS Business Series. 2008 2. Strategic Risk Taking: A Framework for Risk Management. Aswath Damodaran. Wharton School Publishing (by Pearson Education Inc.). 2008 3. Corporate Risk Management by Tony Merna and Faisal F. Al-Thani. John Wiley and Sons Inc. 2008 4. Principles of Corporate Finance by Richard A. Brealey 5. Introduction to Derivatives and Risk Management (with Stock-Trak Coupon) by Don M. Chance and Roberts Brooks, 2009 6. Risk Management for Financial Planners by Christine Barlow, Darlene K. Chandler, Kelly Maheu, and Susan Maloney, 2007 7. COSO Enterprise Risk Management: Understanding the New Integrated ERM Framework. by Robert Moeller. John Wiley and Sons Inc. 2007 8. www.prmia.org (Professional Risk Managers' International Association) 9. http://airmic.com/ International association of insurers and risk managers) 10. http://www.riskmetrics.com (Corporate Metrics. The Benchmark for Corporate Risk Management) 11. http://www.coso.org/( The Committee of Sponsoring of the Treadway Commission) 12. www.swissre.com (Swiss Sigma Research, Swiss Reinsurance Company) 13. www.isda.org (International swaps and derivatives association) 14. www.garp.com (Global Association of Risk Professionals) 1. Risk management and company’s value Quadrants of Risk All of these risks become part of an organization’s overall risk portfolio, which has its own individual risk profile. Risk Profile – a set of characteristics common to all risks in a portfolio. Note: The above risk classifications are general and not meant to cover every risk faced by an organization. There can be overlap among the various categories. Each organization should develop risk classifications that best suit its need for assessing and treating risks. Financial risks definition and characteristics Financial risk is the risk that involves financial loss to firms. Generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more. Two characteristics of financial risk: (1) is an external risk with the potential to affect an organization’s objectives; (2) can be reduced through a financial contract, such as a derivative. Three major types of financial risk: - Market risk (currency exchange rate risk, interest rate risk, commodity price risk, equity price risk, liquidity risk) - Credit risk - Price risk Financial risks overview Risk Categories Characteristics Description Market risk • • • • • Some risks - systematic Have upside and downside potential Risk, which arises from changes in the value of financial instruments Credit risk  Firm-specific risk  Systematic risk Credit risk has only negative potential. If a borrower pays as agreed, there is no realized risk. If a borrower defaults, the downside of risk is realized Firm-specific credit risk is specific to a particular financial institution and is associated with its portfolios of credit transactions Price risk  The price charged for the organization’s products or services  The price of assets purchased or sold by an organization Have upside and downside potential The potential for a change in revenue or cost because of an increase or decrease in the price of a product or an input Currency price risk Interest rate risk Commodity price risk Equity price risk Liquidity risk Equity Price Risk Equity price risk can have various effects on organizations. These effects can be classified as such: • Risks related to an organization’s own share price • Risks related to an organization’s investments in external stocks and other securities • Risks related to the average share price in a market or market sector An organization’s share price can rise or fall for many different reasons. A fall in share price can constrict the organization’s ability to raise capital. Financial organizations typically have significant investments in the securities of other organizations. A change in the price of a major investment can affect a financial institution’s profit. Change in the price of a market index, such as S&P stock index, can have a broad effect on a financial organization’s investment portfolio. Liquidity Risk An organization’s liquidity is related to its cash or its ability to raise cash. It is closely related to an organization’s solvency, which is its ability to meet its financial obligations. Financial institutions have two distinct types of liquidity risk that are inherent to the nature of these organizations:  The possibility that large numbers of clients could withdraw funds (a run on the bank)  The possibility of off-balance sheet commitments, such as a line of credit, being exercised Either one of these types of liquidity risk requires significant amounts of cash (liquidity) that can prevent a financial institution from meeting its objectives or possibly cause the institution’s insolvency. Financial organizations use either stored liquidity or purchased liquidity to manage their liquidity risks. Stored liquidity is the cash reserve of the bank or insurer. Purchased liquidity is cash raised in credit markets. The Bank of Russia may lend emergency funds to a bank that requires liquidity. The goal of financial risk management The goal of financial risk management is risk optimization. Risk management professionals should have a perspective that includes both protecting against downside risk and capturing upside risk. Although most financial risks are external, internal management’s risk appetite and tolerance are key components of each organization’s risk optimization process. Risk Treatment Techniques Because speculative risks can result in both negative and positive consequences, the organization must consider a range of risk treatment techniques or a combination of techniques to manage negative and positive outcomes. For pure risks, the focus of risk treatment is on managing negative outcomes. For events that appear to have primarily positive potential outcomes, such as a major competitor leaving the market, treatment would focus on exploiting the risk by maximizing expected gains. Techniques would include modifying the likelihood of an event to increase the opportunity to meet objectives while also considering treatment options for potential negative outcomes. Risk management process Choose the Form of Risk Treatment Strategy Does financial risk management add value? Risk Management and Shareholders’ Wealth • Valuation Model (DCF): Value = PV(expected cash flows) Value =  E(Cash Flowt ) t 1 (1  r ) t  • where r = opportunity cost of capital = cost of equity + cost of debt – Key Issues: • How does risk management affect – Expected Cash Flows? – Opportunity cost of capital? Investor Diversification & Risk Premium • Intuitively, the risk premium should reflect the risk of the cash flows • riskier cash flows ==> higher risk premium • However, investors can diversify some risk on their own • Divide cash flow risk into two components: • Total Risk = diversifiable risk Does not affect cost of capital + nondiversifiable risk Increases cost of capital • Risk premium only depends on nondiversifiable risk (market/systematic) Break Down of Risks Firm specific – diversifiable risk Market – non-diversifiable How to measure the non-diversifiable risks? Cost of equity - The risk of any asst is the risk that it adds to the market portfolio Statistically, this risk can be measured by how much an asset moves with the market (covariance) - Beta (β) – is a standardized measure of this covariance Beta is a measure of the non-diversifiable risk for any asset can be measured by the covariance of its returns with returns on a market index, which is defined to be the asset's beta. The cost of equity will be the required return: CAPM Model Cost of Equity = Rf + Equity Beta(β) * [E(Rm) – Rf] where, Rf = Riskfree rate E(Rm) = Expected Return on the Market Index Firm specific risks and the cost of debt The cost of debt is the market interest rate that the firm has to pay on its borrowing. It will depend upon three components: (a) The general level of interest rates (b) The default premium (c) The firm's tax rate Capacity to generate cash flow from operations Credit rating Default risks depends on…. Level of financial obligations (%, principal payments) Cost of debt A. Damodoran’s vision of investment risk management Limitations of the CAPM 1. The model makes unrealistic assumptions 2. The parameters of the model cannot be estimated precisely • - Definition of a market index • - Firm may have changed during the 'estimation' period' 3. The model does not work well • - If the model is right, there should be: – a linear relationship between returns and betas – the only variable that should explain returns is betas • - The reality is that – the relationship between betas and returns is weak – Other variables (size, price/book value) seem to explain differences in returns better. Risk and DCF Value Determinants of Value: Cash flows from existing assets Growth Rate during Excess Return Phase Length of period of excess returns Discount Rate (Weighted average of the cost of equity and cost of debt) Risk Hedging, Risk Management and Value Valuation Component Effect of Risk (loss) Transfer Effect of Risk Management Costs of equity and capital Reduce cost of equity for private and closely held firms. Reduce cost of debt for heavily levered firms with significant distress risk May increase costs of equity and capital, if firms increases its exposure to risks where it feels it has a differential advantage. Cash flow to the Firm Cost of risk hedging will reduce earnings. Smoothing out earnings may reduce taxes paid over time. More effective risk management may increase operating margins and increase cash flows. Expected Growth rate during high growth period Reducing risk exposure may make managers more comfortable taking risky (and good) investments. Increase in reinvestment rate will increase growth. Exploiting opportunities created by risk will allow the firm to earn a higher return on capital on its new investments. Length of high growth period No effect Strategic risk management can be a long-term competitive advantage and increase length of growth period. Summary of Why Firms Manage Risk? • Reducing diversifiable risk does not reduce risk for diversified shareholders, but • it can increase expected cash flows available to make value enhancing investments by • • • • reducing the costs of obtaining services avoiding costly external financing improving contractual terms with other claimants reducing expected tax payments Reasons why RM may increase firm’s value increase the use of debt maintain capital budget over time avoid costs associated with financial distress utilize their comparative advantages in hedging relative to the hedging ability of individual investors reduce both the risks and costs of borrowing by using swaps reduce the higher taxes that result from fluctuating earnings Arguments for hedging for value maximizing firms Hedged Un hedged -Reduce the likelihood of financial distress; • decrease the level of direct costs (out-of-pocket cash expenses that must be paid to the third parties in the event of bankruptcy or severe financial distress) • decrease indirect costs (contracting costs involving relationships with creditors, suppliers and employees) • may increase revenue for firms that sell products with warranties or service contracts (customers will place a higher value on them) - Reduce a firm’s expected tax liability; -Makes easier for the board of directors and outsiders to evaluate the performance of managers (superior managers may be more inclined to hedge, whereas inferior managers may prefer to disguise their poor performance behind the firms unhedged risks) To hedge or not to hedge ? Company needs to consider: -Transaction costs -Effectiveness and accuracy of alternative risk transfer strategies -Opportunities to offset underlying risk exposures -Liquidity and default risks Financially engineered hedging strategies are effective and accurate, but suffer from greater transaction costs and low liquidity Exchange traded derivative securities are attractive because of their low transaction costs, high liquidity and low default risk, but not effectively offset risk exposures Hedging to Reduce Taxes and Increase Net Cash Flow Hedging can reduce expected tax liability Simple Example: Company’s earnings directly depends on input price. The higher the earning – the higher the tax rate ($10 000 – 10%; $20 000 – 20%) No price hedging scenario Input price high medium low $0 $ 10 000 $ 20 000 Taxes due 1 000 4 000 After –tax earnings 9 000 16 000 Taxable earnings Expected after tax earnings = 1/3 ($0) + 1/3 ($ 9 000) + 1/3 ($16 000) = $ 8 333 Hedging scenario (price locked in at medium price) Taxable earnings $ 10 000 Taxes due 1 000 After –tax earnings 9 000 How much hedging is necessary? If changes in financial risks lead to large imbalance in supply and demand for funds, then the company should hedge aggressively! If not – company has a natural hedge and doesn’t need to hedge as much! Company should investigate: - How sensitive are CF to risk variables - How sensitive are investment opportunities to those risk variables? Hedging and Cash generating - Example 1 Pharmaceutical company Omega based in the USA Revenue? (ExR risk) -R&D divisions -Factory and other fixed assets Japan 50% of Sales Germany ExR movements scenarios Revenue (CF) Impact Stable $ 200 mln. Dollar appreciates Fall down to $ 100 mln. Dollar depreciates $ 300 mln. Foreign exchange risks affects not only cash flow, but also investment opportunities in the multinational companies. Payoffs from Omega Drug’s R&D Investments R&D level of financing USD 100 mln. Discounted CF 160 NPV of discounted CF 60 USD 200 mln. 290 90 USD 300 mln. 360 60 Omega tells its banks to lock their cash flows of USD 200 mln The effect of hedging on Omega Drug’s R&D Investment and Value Dollar position Value from hedging Internal financing R&D Without Hedging Hedge proceeds Additional R&D from hedging Appreciation + 130* 100 100 +100 100 200 200 - 70** 300 200 -100 Stable Depreciation * Discounted CF 160 – 290 = 130 ** 360-290 = - 70 By hedging company reduces supply when there is excess of funds and increases supply when there is a shortage Regulation of supply for internal funds by Omega Drugs using hedging CF from operations in mln. USD Supply of internal funds (CF from operations) Hedging 200 Demand for funds (R&D investments) Hedging ExR fluctuations Appreciation USD Stable USD Depreciation USD Understanding the connection between a company’s investment opportunities and those key economic variables is critical to develop a coherent risk management strategy Hedging and Cash generating - Example 2 Main risk: Oil Company Omega Oil Price for oil fluctuations based in the USA Company’s supply of internal funds is exposed to oil price risk. When oil prices drop, cash flow declines Company’s demand for funds falls when oil prices decline. When prices lower its less attractive to explore and develop new oil reserves. For an oil company supply for funds tends to match the demand for funds even if the company doesn’t actively manage risk Thee possible level for oil prices Generated CF Amount of investment Low $ 100 mln $ 150 mln Medium $ 200 $ 200 (optimal) High $ 300 $ 250 Omega Oil: Hedging with oil price sensitive instruments CF from operations in mln. USD Optimal hedge for Omega Oil is only a half of Omega Drug Supply of internal funds (CF from operations) Hedging Demand for funds (desired investments) 200 Hedging Price fluctuations Lower Current Higher Risk management program should have a goal to ensure that a company has the cash available to make value enhancing investments How much hedging is necessary? Outcomes… If changes in financial risks (ExR risks, % rate, commodity prices) lead to large imbalance in supply and demand for funds, then the company should hedge aggressively! If not – company has a natural hedge and doesn’t need to hedge as much. Lection 2. Hedging strategies and Risk appetite. FX Hedging strategies Hedging Strategies Risk Management Standards for non-financial companies № Title 1 СOSO Enterprise Risk Management (COSO ERM) Who prepared Where is used Auditors (PWC) Specific Non financial organizations Risk management focused on company’s goals Financial Organizations Risk management focused on business processes risks (2004) 2 Orange book (UK) Risk Managers 3 FERMA (IRM UK) Risk Managers 4 Australia - New Zeeland RM Standards Risk Managers Enterprise Risk Management Model (COSO) 1) Internal environment Above risk appetite Risk appetite 2) Objective setting , Below risk appetite Board of Directors 5) Risk response Tactical objectives 6. Control activities Divisions 7. Information and communications Info about Risks 8. Monitoring Business units 3) Event identification (expert or analytical approach ) 4) Risks assessment (quantitative or qualitative) Risk factor 1 Business Units Risk factor 2 …….. Risk factor N Info about Risks Hedging strategy Key objective: To determine the right level of hedging that define the crucial parameters which translate a hedging strategy into actionable guidelines and measurable benchmarks. In understanding the value drivers of a company’s hedging programme it is important to recognise that hedging an exposure does not necessarily reduce or eliminate the risk, but most likely transforms one risk into another. For example, by hedging forecasted foreign exchange exposure price risk is transformed to forecast risk. In addition, all hedging has the potential to alter a company’s competitive position, for better or worse. Hedging Policy – the Neutral Position and the Appropriate Flexibility/Hedging Band Strategy I. Secure short-term committed exposures It aims at achieving short-term certainty Examples: - hedging a fixed level of committed foreign exchange flows for the next three months - swapping a pre-determined part of floating debt into fixed for the budget year ahead Features: - It does not in itself reduce volatility of either earnings or cash flows, it merely postpones the impact - operational management must take advantage of the time window created by treasury to adjust operations and/or pricing - requires well-developed communication between treasury and operational management - for companies with relatively low risk-appetite Relatively passive risk management approach and would have no/limited flexibility/hedging band attached to the neutral position and typically also a fixed time horizon for hedging Strategy II. Reduce volatility It aims at reducing earnings and/or cash flow volatility over time Examples: - hedging committed and forecasted foreign exchange flows for the next three, six or 18 months - swapping floating debt into fixed debt Features: - could be combined with an objective of hedging the risk of extreme levels - it requires treasury making the right decisions on both timing and extent of their hedging transactions - it may well be appropriate and rational for a company with a relatively high risk profile (appetite) - requires regular monitoring of the markets and an active evaluation of risks and opportunities This could be regarded as being an active or pro-active risk management approach. It requires more flexibility than Strategy I. Strategy III. Achieve best rates/ beat the market Attempt to lock in rates when they appear to be at favorable levels in the cycle To achieve cheap funding or to fix foreign currency denominated cash flows at rates that are at cyclically high or low levels Features: - the treasury policy will need to allow significant flexibility in regards to how much foreign exchange and interest rate exposure (and other treasury risks) to hedge and how far in the future treasury can hedge cash flows - riskiest of the three hedging strategies described, because the company could get locked into unfavorable interest and foreign exchange rates - requires constant monitoring of the markets and equally constant evaluation of risks and opportunities Could be regarded as being a pro-active/ aggressive risk management approach Strategy to hedge corporate FX risk When to hedge? Cash flow volatility (foreign currency) High Don’t hedge due to high costs Hedging optional Low Low Hedge uncertain cash flows using options Hedge significant proportions of cash flows using forwards High Currency volatility Layered hedge approach with uncertain cash flows Layered Hedges Maturity (months) Hedging proportion (%) 6 12 100 75 18 24 50 25 For most companies business results are easier to predict over shorter time horizons, than over longer ones, so the cash flow volatility increases with their maturity. Layered hedge approach with uncertain cash flows Maturity (month) Option proportion Forward proportion 6 12 18 24 10 90 15 60 20 30 25 The higher the uncertainty of future cash flows, the higher the share of options in the portfolio. If the cash flow exposures are expected to last for a long time and the company estimates that exchange rate (for instance EUR/USD for EU based company) exhibits a mean reverting pattern, a company can create a dynamic strategy. Dynamic hedging policy for a USD seller/ EUR buyer: hedging proportion Forward EUR/USD level Favorable Maturity (month) 6 12 18 24 < 1.10 1.10 – 1.30 100 100 100 75 100 50 100 25 > 1.30 100 50 Layered strategy is applied The key idea is that if a company knows that it will have a certain risk exposure over a long period of time , it will increase its hedging proportion at the time when the forward rates are in its favor. Two problems with this strategy: - if the EUR strengthens above 1.30, the company will reduce its hedging horizon from 24 months to 12, which may be considered too risky; - if the EUR is in the favourable region below 1.10, company would be required to hedge 100% of its 12-month, 18-month and 24-month exposures, which could cause it to overhedge, since longerdated cash flows have increasing uncertainty Budget (benchmark) FX rates Companies define the benchmark rate in many ways. Spot rate Forecast rate: from one institution, a consensus rate or some other combination. Forward rate: the implied future rate from the swap curve. External benchmark: comparison against an external benchmark, eg, peer group. Combination. Each approach has a downside. Forecast rates are notoriously unreliable, while forward rates tend to overestimate the evolution of short term rates. In any case, when benchmarking a company’s risk management strategy against alternatives, it is important to do so in a risk-adjusted way, ie, how well company could perform with another strategy, but with the same amount of risk. There is no point in comparing the rate against a better one that is realised with a much more aggressive risk management strategy. Forward exchange rates Forward exchange rate is the exchange rate at which a party is willing to enter into a contract to receive or deliver a currency at some future date. Forward exchange rate is just a function of the relative interest rates of two currencies:  N  1  rd    360   F  S  N  1  rf     360  S rf rd - Spot exchange rate - Foreign currency interest rate for N-days - Domestic currency interest rate for N-days If the spot USD/CAD rate is 1.1239 and the three month interest rates on CAD and USD are 0.75% and 0.4% annually respectively, then calculate the 3 month CAD/USD forward rate Transaction and Translation Risks Illustration of Currency exchange rate Transaction Risk Transaction risk arises whenever a company has a committed cash flow to be paid or received in a foreign currency. The risk often arises when a company sells its products or services on credit and it receives payment after a delay, such as 90 or 120 days. It is a risk for the company because in the period between the sale and the receipt of funds, the value of the foreign payment when it is exchanged for home currency terms could result in a loss for the company. The reduced home currency value would arise because the exchange rate has moved against the company during the period of credit granted Transaction risk - Concept Check U S Company has a home currency of U.S. dollars (US) and it sells a printing machine to an Australian customer, which pays in its home currency of Australian dollars (AU) in the amount of $2 million. In scenario A, the sales invoice is paid on delivery of the machine In scenario B, the customer is allowed credit by the company, so AU$2 million is paid after 90 days. What is the amount of transaction losses for US Company? Concept check. Transaction risks in Company A At 30 September 2008 company received a Bill for the imported chrome plated disks DIABLO amounted 110 350 USD. A delay allowed under the payment of the Bill is March, 17th 2009. Dynamics of currency exchange rate: USD/Rub. from 29.03.2008 to 29.03.2009 Date C ExR A. 30.09.2008 25,2464 B. 11.11.2008 (trend indicated) 26,9639 C. 17.03.2009 34,8388 1. What is the amount of FX risks? 2. What can be a KRI for ExR prepared by Financial manager? B A Hedging instruments for Company A Future contracts At the 11th of November2008, there were available settlement future contracts (on FORTS), which had value 29,620 RUR/USD with expiration on March, 16th, 2009 (SiH9) The size of guarantee maintenance is 3 % of a contact amount. The commission for 1 future – is insignificant (less than 1 RUR. for 1 contract for 1000 USD) and can be ignored. Option contracts At the 11th of November2008, there were available options call with strike 30 RUR/USD with delivery on 14.03.2009. Option premium was 850 RUR for 1 contract for 1000$. Translation Risk Translation risk arises, when a company that has operations overseas will need to translate the foreign currency values of each of these assets and liabilities into its home currency. It will then have to consolidate them with its home currency assets and liabilities before it can publish its consolidated financial accounts - its balance sheet and profit and loss account. The translation process can result in unfavorable equivalent home currency values of assets and liabilities. Translation risk - Concept Check A simple balance sheet example of a company whose home (and reporting) currency is in British pounds (£) When year two's assets and liabilities are consolidated, the foreign asset is worth £100 (a 50% fall in value in £ terms). For the balance sheet to balance, liabilities must equal to assets. The adjustment is made to the value of equity, which must decrease by £100 so liabilities also total £200. The adverse effect of this equity adjustment is: - the value of equity is much lower - not a pleasant situation for shareholders whose investment was worth £100 last year