LEXIBLE STR
$
F UCTURE
MANAGING
$
FINANCIAL RISK
by Simon
n my 10 years managing finance/trea-
I
sury departments, I have spent consid-
erable effort addressing the financial
imperatives of two of Canada’s largest
corporations: cash management,
including banking and committed lines
of credit; external financings, averaging
$1 billion per year, in the global capital mar-
kets; early calls of publicly held debt; deriva-
tives; pension funds; debt rating agencies; and
all the other associated functions that are the
bread and butter of our daily corporate finance
lives. Yet, I always felt a need for a greater
structure that would bring together these func-
tions and the people who implement them—a
flexible structure that would encourage the
innovation required to create financial benefits
and shareholder value.
While on vacation two years ago on a peace-
ful, somewhat remote, island off the west coast
of Florida, I spent a few evenings churning out
concepts, financial instruments, risks and func-
tions as they randomly occurred to me. Before I
knew it an entire wall was blanketed with yel-
low notes. The next few evenings were spent
rearranging the ideas and concepts into a struc-
ture. While none of the parts of the process are
innovative on their own, my subsequent dis-
cussions with both Canadian and U.S. corpora-
Jegher
tions and investment bankers point to the fact
that, other than in financial institutions, a uni-
fied and comprehensive financial risk manage-
ment focus is likely an exception.
The objective of such a process is, first and
foremost, to address the key policies relating to
financial risk exposures. For example, credit
ratings are too often seen as simply the fallout
of financial performance, not the result of poli-
cies tailored to attaining a specific rating that
addresses a firm’s long-term capital require-
ments. A credit rating policy can set up other
capital structure strategies and an appropriate
fixed/floating composition of the debt portfolio.
Another objective of a unified process is to
foster a consolidated perspective of financial
risk—not only the risk to the company itself,
but its subsidiaries and parent, where applica-
ble. Similarly, for companies with defined bene-
fit pension plans, the plan’s assets and liabilities
must also be incorporated into this consolidated
perspective, recognizing that financial risks
affecting off-balance-sheet items can have signif-
icant impacts on cash flows and net income.
Finally, a comprehensive process brings to light
the dynamics between disciplines, thus focusing
various operating units on common objectives.
For example, liquidity policy will affect the tim-
ing of capital market transactions just as foreign
JANUARY 1999 / RISK MANAGEMENT 29
A FLEXIBLE STRUCTURE

Portfolio and Exposure Management

RISK CATEGORY
-1-
Foreign Interest Counterparty/
Risk Liquidity
Exchange Rates Credit Exposure
Identification

-2-
Policy Development

•Short and Longer Term Business and Financial Plans

Risk
•Pension Fund Exposure
Quantification

Business Review Budgeting Forecasts: Cost of equity, asset cash flow matching, subsidiaries,
pension fund, business cycle correlation
-3-
Operating
Operating Environment: External financing requirements, tax (current and forecasted rate),
Environment economic and capital markets
Assessment
Rating Agencies: Rating outlook, debt capacity, view of financial instruments
FINANCIAL PROCESS

-4-
Development of Acceptable Risk Tolerances: e.g., budget variances, rating implication,
Risk cash flow variances, trust indenture
Tolerances
Communication
• Executive approval
-5- Development of Policies and Objectives Counterparty Policy
• credit rating • Board approval
Policies • Target credit rating
• institutions
& • Capital structure and dividend policy
• notional limits
Objectives • Duration and fixed-floating mix of debt • swap agreements

Portfolio Management Approach

Review and analyze risk reduction/elimination strategies and instruments
Strategy Implementation & Evaluation

Portfolio Software
• evaluation
• implementation

• caps
-6-
• commercial paper • floors
Strategy program • collars • fixed-floating ratio consolidated counter-
& • maturity distribution • forwards • duration party exposure model
Implementation • lines of credit • swaps
• etc.

• securities buyback
• interest rate hedging arbitrage • medium-term
• option monetization note program • swap agreements
• early calls efficiency
analysis

• Funds control, monitoring and processing

Controls:
-7- • Segregation of implementation and monitoring Communication
Risk • Board of Directors
• Audit Committee
Controls
• Financing Committee
& Monthly and Quarterly Capital Portfolio Reporting:
• CFO
Trust Indenture
Reporting • Rating Agencies
Dividend Certificate
• Subsidiaries
Economic/market developments, monitoring, reporting, sensitivity analysis

-8-
Performance
Development and Measurement of Benchmark Portfolio and Risks
Measurement
& Evaluation

exchange policy will affect the nature of deriva- management process is the identification of the
tive strategies. various risks.
Liquidity Risk—Even companies with a
Policy Development highly tuned focus on customer and sharehold-
The first step in creating an active financial er value can go bankrupt because they lack

30 RISK MANAGEMENT / JANUARY 1999

DOLLAR RISKS
short-term liquidity. Short- and longer-term
cash forecasts, combined with worst-case busi-
ness and economic scenarios, are vital for the
development of a corporate liquidity policy. In
turn, this policy will drive ceiling short-term
debt levels, the size and term of committed
bank lines of credit and the timing of fixed,
long-term financings.
Foreign Exchange Risk—A question: Unless
your company is a financial institution, why are
you taking any foreign exchange risk at all?
Corporate risks should be taken in areas of the
company’s core expertise. However, analyzing
your corporation’s FX exposure will raise some
interesting questions. What exposures are built
into the supply procurement process? If you
have a defined benefit pension fund, what is
the potential impact of currency exposures?
While currency risk is integral to the pension
fund’s investment diversification strategy, an
FX gain or loss could impact the sponsor cor-
poration’s cash contributions to the pension
fund. These and other questions particular to
your firm’s operations will raise policy issues
that might otherwise go unaddressed.
Interest Rate Risk—The key policy issue that
determines a firm’s interest rate risk is capital
structure. Thereafter, the primary measure of a
company’s debt portfolio interest risk should be
duration, which is driven by cash flows, as
opposed to simply utilizing the average life of
the portfolio. Ideally, the duration of the debt
portfolio should be equal to the duration of the
firm’s assets—an objective that is difficult to
apply to most companies unless they are finan-
cial institutions. Having established a duration
policy, the key implementation decision is
determining a fixed/floating mix of debt that sat-
isfies both liquidity and interest rate policies. At
Bell Canada, we have assessed a number of the-
oretical, custom-designed studies, all of which
point to an approximate 80 percent to 20 per-
cent mix of fixed/floating debt as being the most
effective over the longer term.
Counterparty/Credit Exposure—A key
advantage to derivatives as a risk management
tool is that they allow for the modulation of
duration without necessarily increasing liquidi-
ty risk. The best example is borrowing
long/fixed and swapping into floating.
Similarly, derivatives can be a cost-effective and
flexible vehicle for implementing a foreign
exchange policy. Their use, however, comes at
a price. Derivatives result in counterparty credit
exposure which itself requires a clear policy
and operating controls. This policy should
address credit criteria and specific credit limits
on a consolidated corporate basis, including
32 RISK MANAGEMENT / JANUARY 1999
any exposures that undoubtedly exist in the
pension fund’s equity and debt portfolios.
Given the publicity surrounding their occasion-
al abuse, the use of derivatives might be seen as
a hard sell to a board of directors. My experi-
ence has shown that boards are receptive to
derivative use if there is a clear objective of
restricting their use to managing, controlling
and reducing risk combined with appropriate
internal controls and reporting.
Quantification
Having identified the firm’s financial risks, the
next step in the process is to quantify the dollar
risk associated with each of them. This requires
a dynamic financial model that incorporates the
firm’s consolidated financials, long-term busi-
ness plans and off-balance-sheet items such as
pension fund assets and liabilities, leases,
derivatives in place and securitization transac-
tions such as the sale of receivables.
Quantification will require a risk assessment
based on various business and economic sce-
narios.
Assessment
The next step in the process involves a thor-
ough assessment of the business and operating
environment. For example, how is the firm’s
business correlated to the economic cycle? A
high correlation might imply that the firm is
capable of assuming higher interest rate risk,
assuming rates increase as the economy heats
up. Similarly, a firm whose markets are aggres-
sively under attack and whose base technology
is undergoing rapid change should consider
taking relatively lower financial risks. (While
this sounds obvious, too many firms groping to
be competitive attempt to reduce financial costs
by making short-term capital market bets.)
Another aspect that requires assessment is the
firm’s prospective view of its long-term debt
credit ratings. This total environmental assess-
ment determines the appropriate level of finan-
cial risk.
Risk Tolerance
The level of risk tolerances that a corporation is
prepared to accept should encompass the
aggregate of all the identified financial risks and
is dependent on a number of factors. How
much variance in budgeted earnings and cash
flows is tolerable to management, the board
and the shareholders/capital markets? What
will be the reaction of the rating agencies to dif-
ferent levels of earnings and cash flow volatili-
ties? How much room for variance exists in the
company’s debt trust indenture tests?
 These are just a few of the questions that
will need to be answered in arriving at the
next step: developing the core financial poli-
cies that make up the foundation of the pro-
cess leading toward strategy development and
implementation.
(A point of clarification: The process should
not be misinterpreted to imply that
$
finance/treasury should be a profit center. On
the contrary, the process is focused on hedging
versus speculation. Its operating philosophy is
to reduce both risk and cost. It does require
management to take certain views on market
movements; but doing nothing to develop risk
tolerance policies is in fact speculating with the
company’s current financial exposures.)
Implementation
Having developed a set of financial risk policies
approved by the board of directors, the next
step is implementation and assuring that poli-
cies are adhered to. The intellectual foundation
must be one of managing the entire lower right
hand side of the balance sheet as a single port-
folio that finances the corporation’s operations,
with the focus on cash flows generated from
both sides of the balance sheet.
Strategy implementation is the more familiar
of corporate financial operations and calls for a
comprehensive array of tools. The key tool is
the development, or purchase, of a financial
model for the corporation’s portfolio of out-
standing debt, preferred shares and equity. This
model should be capable of dynamically simu-
lating the impact of various scenarios on the
portfolio and the various financial risks, thus
ensuring constant adherence to policy. It must
be capable of measuring counterparty exposure
and assessing the impact of various derivative
strategies. My experience has shown that
investment banking firms are in the best posi-
tion to assist in the development of this model.
Other vital tools in managing the capital
portfolio include both a commercial paper pro-
gram and a medium-term note program. The
key advantage of these vehicles is the flexibility
they provide in managing the duration of the
capital portfolio. Commercial paper can be an
important tool in attaining a target floating debt
level and medium-term notes are perfectly suit-
ed to slotting in debt maturities in years where
room exists based on liquidity policy. This flex-
ibility is further enhanced when combined with
interest or cross currency swaps.
Communication
In policy development, the decision-making
and approving body should be the board of
directors. This role for the board is appropriate
and consistent with recent studies and recom-
mendations on the subject of corporate gover-
nance. In a study entitled “Where Were the
Directors? Guidelines for Improved Corporate
Governance in Canada,” the Toronto Stock
Exchange identified five stewardship responsi-
bilities for a board of directors. The proposed
financial risk management process specifically
addresses two of the five:
1. the identification of the principal risks of
the corporation’s business and ensuring the
implementation of appropriate systems to
manage these risks
2. ensuring the integrity of the corpora-
tion’s control and management information
systems
Thus, obtaining approval from the board of
directors with respect to adopting the suggested
risk management process should be consistent
with the board’s own view of its managing
responsibilities.
Similarly, communication should be integral
to the operational risk management control
process. The audience for this communication
varies in terms of both the information provid-
ed and the frequency of the reporting. From a
corporate governance perspective, the key
audience is the board of directors or its audit
committee. The implementation of a compre-
hensive financial risk management process
might also justify the creation of a finance com-
mittee of the board.
Finally, I believe that the debt rating agen-
cies should be apprised of these key financial
risk policies and the process in place to actively
manage and control them. The very fact that
senior management and the board are taking
ongoing interest in addressing the very risks
that are uppermost in the minds of the rating
agencies conveys a positive signal respecting
the quality of the earnings and cash flows that
support the corporation’s outstanding debt and
interest obligations.
A Continuous Process
Every process that strives for excellence is cir-
cular—after implementation, performance
must be measured against the objectives origi-
nally defined and the entire process evaluated
for continuous improvement. A corporation’s
financial policies and the capital portfolio that
was the outcome of those policies must be
reevaluated based on changing corporate objec-
tives combined with altered business and eco-
nomic circumstances. RM
JANUARY 1999 / RISK MANAGEMENT 33