FY - Risk Management Primer

Financially Yours
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Preparation
Primer
Risk Management
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Risk Management
1. Risk Definition
Business risk is the exposure a company or organization has to factor(s) that will lower
its profits or lead it to fail. Anything that threatens a company's ability to achieve its
financial goals is considered a business risk
2. What is Risk Management?
• It is the process of assessing threats, taking steps to mitigate risk to an acceptable

level, and maintain or reduce that level of risk
• It is the process of identifying, analyzing, and addressing risks proactively throughout
the project lifecycle
Organizations face many different types of risk. These include risks associated with
(a) the business environment,
(b) laws and regulations,
(c) operational efficiency,
(d) the organization’s reputation, and
(e) financial risks
3. Financial Risks
These financial risks relate to the financial operation of a business – in essence, the risk
of financial loss (and in some cases, financial gain) – and take many different forms.
These include currency risks, interest rate risks, credit risks, liquidity risks, cash flow risk,
and financing risks. The importance of these risks will vary from one organization to
another. A firm that operates internationally will be more exposed to currency risks than
a firm that operates only domestically; a bank will typically be more exposed to credit
risks than most other firms, and so forth
Risk reporting and risk disclosure are also becoming increasingly important as
stakeholders wish to know more about the risks that their organizations are taking.
Although risk management is primarily concerned with managing downside risk – the
risk of bad events – it is important to appreciate that risk also has an upside. This upside
involves the exploitation of opportunities that arise in an uncertain world, such as
opportunities to profit from new markets or new product lines.
Risk management is therefore concerned both with conformance that is, controlling the
downside risks that may threaten achievement of strategic objectives and with
performance such as opportunities to increase a business’s overall return. In this way,
risk management is linked closely with achieving the organization’s objectives, and
involves the management of upside as well as downside risks.
Financial risks create the possibility of losses arising from the failure to achieve a
financial objective. The risk reflects uncertainty about foreign exchange rates, interest
Financially Yours 1 Preparation Primers

Risk Management
rates, commodity prices, equity prices, credit quality, liquidity, and an organization’s
access to financing. These financial risks are not necessarily independent of each other.
For instance, exchange rates and interest rates are often strongly linked, and this
interdependence should be recognized when managers are designing risk management
systems
4. Types of Financial Risks
4.1. Market Risks: These are the financial risks that arise because of possible losses due
to changes in future market prices or rates. The price changes will often relate to
interest or foreign exchange rate movements, but also include the price of basic
commodities that are vital to the business.
• EXAMPLE: CADBURY’S SCHWEPPES’ EXPOSURE TO FOREIGN EXCHANGE RATE

RISK
The confectionery giant, Cadbury Schweppes, recognized in its 2007 annual

report that it has an exposure to market risks arising from changes in foreign
exchange rates, particularly the US dollar. More than 80% of the group’s
revenue is generated in currencies other than the reporting one of sterling. This
risk is managed by the use of asset and liability matching (revenue and
borrowings), together with currency forwards and swaps.
4.2. Credit Risks: Financial risks associated with the possibility of default by a counter-
party. Credit risks typically arise because customers fail to pay for goods supplied on
credit. Credit risk exposure increases substantially when a firm depends heavily
upon a small number of large customers who have been granted access to a
significant amount of credit. The significance of credit risk varies between sectors,
and is high in the area of financial services, where short- and long-term lending are
fundamental to the business.

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A firm can also be exposed to the credit risks of other firms with which it is heavily
connected. For example, a firm may suffer losses if a key supplier or partner in a joint
venture has difficulty accessing credit to continue trading.
• EXAMPLE: AMAZON’S CREDIT RISKS
Amazon, the global online retailer, accepts payment for goods in a number of
different ways, including credit and debit cards, gift certificates, bank checks,
and payment on delivery. As the range of payment methods increases, so also
does the company’s exposure to credit risk. Amazon’s exposure is relatively
small, however, because it primarily requires payment before delivery, and so
the allowance for doubtful accounts amounted to just $40 million in 2006,
against net sales of $10,711 million.
• EXAMPLE: CREDIT RISK MANAGEMENT IN THE BANK OF AMERICA
In its 2007 annual report (p.69), Bank of America states that it manages credit
risk “based on the risk profile of the borrower or counterparty, repayment
sources, the nature of underlying collateral, and other support given current
events, conditions and expectations.” Additionally, the bank splits its loan
portfolios into consumer or commercial categories, and by geographic and
business groupings, to minimize the risk of excessive concentration of exposure
in any single area of business.
4.3. Financing, liquidity and cash flow risks: Financing risks affect an organization’s
ability to obtain ongoing financing. An obvious example is the dependence of a firm
on its access to credit from its bank. Liquidity risk refers to uncertainty regarding the
ability of a firm to unwind a position at little or no cost, and also relates to the
availability of sufficient funds to meet financial commitments when they fall due.
Cashflow risks relate to the volatility of the firm’s day-to-day operating cash flow.
• EXAMPLE: A CREDIT TRIGGER
Banks often impose covenants within their lending agreements (e.g., a

commitment to maintain a credit rating), and access to credit depends on
compliance with these covenants. Failure to comply creates the risk of denial of
access to credit, and/or the need to take action (and costs involved) to restore
that rating.
For example, the 2005 annual report of Swisscom AG shows that the company
entered into a series of cross- border tax lease arrangements with US Trusts, in
which sections of its mobile networks were sold or leased for up to 30 years,
and then leased back. The leasing terms included a commitment by Swisscom
AG to meet minimum credit ratings. In late 2004, however, a downgrading by
the rating agencies took the company’s credit rating to below the minimum

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specified level. As a result, Swisscom AG incurred costs of Swiss Francs 24

million to restore that rating.
• EXAMPLE: HOW NOT TO MANAGE FINANCING RISK: NORTHERN ROCK
The UK bank Northern Rock provides a classic example of a company that

succumbed to financing risk. Its business model depended upon access to large
levels
of wholesale borrowing. But in late 2007, this funding dried up during the
“credit crunch” that arose out of the US subprime mortgage crisis. Without
access to loans from other commercial banks, Northern Rock was unable to
continue trading without emergency loans from the Bank of England to bridge
its liquidity gap. However, even massive emergency loans were unable to
restore investor confidence in the bank, and the British Government eventually
felt compelled to nationalize it.
5. Why Manage Financial Risk?
Firms can benefit from financial risk management in many different ways, but perhaps the
most important benefit is to protect the firm’s ability to attend to its core business and
achieve its strategic objectives. By making stakeholders more secure, a good risk
management policy helps encourage equity investors, creditors, managers, workers,
suppliers, and customers to remain loyal to the business. In short, the firm’s goodwill is
strengthened in all manner of diverse and mutually reinforcing ways. This leads to a wide
variety of ancillary benefits:
• The firm’s reputation or ‘brand’ is enhanced, as the firm is seen as successful and its
management is viewed as both competent and credible.
• Risk management can reduce earnings volatility, which helps to make financial
statements and dividend announcements more relevant and reliable.
• Greater earnings stability also tends to reduce average tax liabilities.
• Risk management can protect a firm’s cash flows.
• Some commentators suggest that risk management may reduce the cost of capital,
therefore raising the potential economic value added for a business.
• The firm is better placed to exploit opportunities (such as opportunities to invest)
through an improved credit rating and more secure access to financing.
• The firm is in a stronger position to deal with merger and acquisitions issues. It is
also in a stronger position to take over other firms and to fight off hostile takeover
bids
• The firm has a better managed supply chain, and a more stable customer base.

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6. Risk Management Cycle/Framework
Risk management cycle, illustrated above, shows that risk management forms a
control loop that starts with defining risks by reference to organizational goals, then
progressing through a series of stages to a reassessment of risk exposures following
the implementation of controls.
At the organizational level, the stages of the risk cycle are set against the background
of a clearly articulated risk policy. Drafted by senior management, the policy
indicates the types of risks senior management wants the organization to take or
avoid, and establishes the organization’s overall appetite for risk taking. The starting
point is therefore a general understanding of (a) the range and type of risks that an
organization may face in pursuing its specific strategic objectives, and (b) the scale
and nature of any interdependencies between these risks. This overview can then be
used as the basis for constructing a more detailed risk management strategy for each
risk category – in this case, financial risks.
Based on the cycle illustrated, the core elements of a financial risk management
system are:
• Risk identification and assessment

• Development of a risk response
• Implementation of a risk control strategy and the associated control
mechanisms
• Review of risk exposures (via internal reports) and repetition of the cycle

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6.1. Risk Identification and Assessment
• The first stage is to identify the risks to which the organization is exposed. Risk
identification needs to be methodical, and to address the organization’s main
activities and their associated risks. Risk identification may be carried out via
questionnaires, surveys, brainstorming sessions, or a range of other techniques such
as incident investigation, auditing, root cause analysis, or interviews. The aim is to
use staff expertise to identify and describe all the potential financial risks to which
the organization may be exposed.
• The scale of each identified risk is then estimated, using a mix of qualitative and
quantitative techniques.
• After this, risks are prioritized. The resulting risk ranking should relate directly back
to overall corporate objectives. A commonly used approach is to map the estimated
risks against a likelihood/impact matrix, such as that illustrated below. Often, both
likelihood and impact would be classified into high, medium, or low. The more likely
the outcome, and the bigger the impact, the more significant the risk would become.
And it is especially important to identify and assess those risks that have the
potential to severely jeopardize the organization’s ability to achieve its objectives, or
even to threaten its very survival.
6.2. Risk Response
• The organization then needs to respond to the risks it has identified. An example
would include setting out a policy defining the organization’s response to a particular
risk, and explain how that policy fits in with its broader objectives.
• It would also (a) set out the management processes to be used to manage that risk,
(b) assign responsibility for handling it, and (c) set out the key performance
measures that would enable senior management to monitor it. In more serious
cases, it might also include contingency plans to be implemented if a projected event
actually occurred.
• The organization should take account of the effectiveness of alternative possible
responses. This requires that it
be possible to identify the level of “gross” risk prior to
a response, and the level of “net” risk left after it. The organization should also take
account of the costs and prospective benefits of alternative responses, as well as
take account of how any response would relate to its risk appetite and its ability to
achieve its strategic objectives.
• The possible responses can be categorized into three categories, as illustrated in the
figure below:

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6.3. Risks Strategies & Tools
• Internal strategies: Imply a willingness to accept the risk and manage it internally
within the framework of normal business operations. An example would be a
decision to use the customer’s currency for pricing of all exports, and using
internal netting processes to manage currency exposures.
• Risk sharing strategies: relate to strategies that mitigate or share risks with an
outside party. An example would be a forward contract, which ‘locks in’ a
particular future price or rate. This prevents losses from unfavourable currency
movements, but locks the buyer into a fixed future exchange rate. Another
example is a joint venture.
• Risk transfer: involves paying a third party to take over
the downside risk, while retaining the possibility of taking advantage of the
upside risk. An option, for example, creates the opportunity to exchange
currency at a pre- agreed rate, known as the strike price. If the subsequent
exchange rate turns out to be favorable, the holder will exercise the option, but if
the subsequent exchange rate is unfavourable, the holder will let it lapse. Thus,
the option protects the holder from downside risk while retaining the possible
benefits of upside risk. Note, by the way, that the greater flexibility of risk
transfer tools is usually accompanied by greater cost.
7. Risk Control Implementation
Having selected a risk response, the next stage is to implement it and monitor its
effectiveness in relation to the specified objectives. Implementation includes allocating
responsibility for managing specific risks and, underlying that, creating a risk-aware culture
in which risk management becomes embedded within the organizational language and
methods of working.

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7.1. Review of Risk Exposures
The control loop is closed when the effectiveness of the risk controls is evaluated
through a reporting and review process. This then leads to a new risk identification and
evaluation process. This process itself has three main components:
• Review process: This should include a regular review of risk forecasts, a review of
the management responses to significant risks, and a review of the organization’s
risk strategy. It should also include the establishment of an early warning system
to indicate material changes to the risks faced by the organization.
• Internal reporting to the board or senior management group: This might include
a
(a) review of the organization’s overall risk management strategy, and (b)
reviews of the processes used to identify and respond to risks, and of the
methods used to manage them. It should also include an assessment of the costs
and benefits of the organization’s risk responses, and an assessment of the
impact of the organization’s risk management strategy on the risks it faces.
• External reporting: External stakeholders should be informed of the
organization’s risk management strategy, and be given some indication of how
well it is performing.
8. Quantifying Financial Risks
Managers need to know the scale of the risk they face before they can decide upon
the response.
Three commonly used approaches to quantifying financial risks are regression

analysis, Value-at-Risk analysis, and scenario analysis. It is helpful to look at each
method in more depth to understand their respective strengths and weaknesses.
8.1. Regression Analysis
Regression analysis involves trying to understand how one variable – such as cash
flow – is affected by changes in a number of other factors (or variables) that are
believed to influence it. For example, the cash flow for a UK-based engineering
business may be affected by changes in interest rates (INT), the euro/sterling
exchange rate (EXCH), and the price of gas (GAS). The relationship between the
variables can be expressed as follows:
Changeincashflow=∂+ß1INT+ß2EXCH+ß3GAS+ε
where INT represents the change in interest rates, EXCH represents changes in the
euro/sterling exchange rate, GAS represents changes in the commodity price, and ε
represents the random error in the equation. The random error reflects the extent to
which cash flows may change as a result of factors not included in the equation.

Risk Management
The coefficients ß1, ß2, and ß3 reflect the sensitivity of the firm’s cash flows to each
of the three factors. The equation is easily estimated using standard packages
(including Excel), and the estimated coefficients can be used to determine the firm’s
hedging strategy.
To continue the example, suppose ß2 is negative, implying that the firm’s cash flow
would fall if the exchange rate went up. If the firm wished to hedge its cash flow
against such an event, then it might do so by taking out a forward contract. If the
exchange rate rose, the resulting drop in cash flow would be countered by an
equivalent rise in the value of the forward contract. Thus, assuming the hedge
position was properly designed and implemented, the result is to insulate the firm
against a change in the exchange rate.
8.2. Value-at-Risk
Another popular approach to risk measurement is Value- at-Risk (VaR) analysis. The
VaR can be defined as the maximum likely loss on a position or portfolio at a
specified probability level (known as the confidence level) over a specified horizon or
holding period. So, for example, a company may own an investment portfolio on
which the risk manager estimates the VaR to be $14 million, at a 95% confidence
level over a ten-day holding period. This means that if no investments are bought or
sold over a ten-day period, then there is a 95% chance of the portfolio falling by no
more than $14 million. VaR is therefore an estimate of the likely maximum loss, but
actual losses may be either above or below VaR.
The VaR is an attractive approach because it is expressed in the simplest and most
easily understood unit of measure, namely dollars lost, and because it gives us a
sense of the likelihood of high losses. However, VaR also has a serious drawback: it
tells us nothing about what to expect when we experience a loss that exceeds the
VaR. If the VaR at a particular confidence level is $10m, we have no idea whether to
expect a loss of $11m or $111m when losses occur that are greater than the VaR.
• EXAMPLE: MICROSOFT’S USE OF VaR TO MANAGE ITS FINANCIAL RISKS
Where companies have global operations that trade across a range of

currencies and interest rate regimes,
it is quite likely that such currency and interest rate risks interact. Historically,
companies have tended to hedge risks independently as transactions occur, but
VaR
can treat the various risks as a portfolio of related components that can be
managed together. Microsoft is one example of a company that uses VaR to
manage aggregate risks in this way. Currency, interest rate, and
equity/investment risks are hedged in combination to take advantage of the
effects of diversification within the portfolio. The company then uses simulation
analysis to estimate and report a VaR figure that shows the potential loss on

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the combined risk exposures, assuming a 97.5% confidence limit and a 20-day
holding period. Microsoft draws attention to the fact that the VaR amount does
not necessarily reflect the potential accounting losses. Nonetheless, the fact
that VaR is used at all indicates active risk management, giving a positive signal
to the market. The VaR can then be compared to overall reported earnings as a
sensitivity measure.
8.3. Scenario Analyses
Another useful approach to quantifying risk involves scenario analyses (sometimes

also referred to stress tests, sensitivity tests, or ‘what if?’ analyses). These involve a
financial model of the firm and a set of specified scenarios. We ask ‘what if’ one or
more scenarios should occur, and we use the model to determine the impact of
these scenarios on the firm’s financial position. The scenarios chosen include any we
believe might be relevant to our organization. For example, we might ask:
• “What if the stock market crashed by 20%?”

• “What if interest rates were to rise by 300 basis points?”
• “What if the exchange rate were to fall 10%?”
• “What if a firm were to lose a key client or key market?”
• And so forth.
If we wish to, we can then convert the results of the scenario analyses into a risk
measure by assuming the risk exposure to be equal to the largest of the forecast
scenario analysis losses.
Firms have used scenario analyses in some form or other for many years. Early
scenario analyses were often little more than ‘back of the envelope’ exercises, but
the methodology has improved considerably over the years, thanks in large part to
improvements in spreadsheet technology and computing power. Modern scenario
analyses can be highly sophisticated exercises.
Scenario analyses are particularly helpful for quantifying what we might lose in crisis
situations where ‘normal’ market relationships break down. Scenario analyses can
identify our vulnerability to a number of different crisis- phenomena:
• Changes in the cost and availability of credit: Scenario analyses are ideal for
evaluating our exposure to an (a) increase in the cost, and (b) decrease in the
availability, of credit.
• Sudden decreases in liquidity: Markets can suddenly lose liquidity in crisis
situation, and risk management strategies can easily become unhinged, leading
to much bigger losses than anticipated.
• • Concentration risks: Scenario analyses can sometimes reveal that we might
have a much larger exposure to a single counterparty or risk factor than we had
realized, taking into account the unusual conditions of a crisis. Probability-based
measures such as VaR can overlook such concentration, because they tend not to
pay much attention to crisis conditions.

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• Macroeconomic risks: Scenario analyses are well suited for gauging a firm’s
exposure to macroeconomic factors such as the state of the business cycle,
sudden exchange rate changes, and the economic condition of a particular
country.
EXAMPLE: NORTHERN ROCK’S LIQUIDITY PROBLEMS
The importance of liquidity-related scenario analyses was highlighted by the fate

of the British bank Northern Rock in 2007; they had failed to carry out such
analyses even though their business model made the bank very dependent on
financing from the capital markets. The failure to anticipate a possible drying up
of market liquidity was a key factor in the bank’s subsequent demise.
EXAMPLE: CADBURY SCHWEPPES’S INTEREST-RATE AND FOREIGN-EXCHANGE

RATE RISK EXPOSURE
The results of scenario analyses can be reported to shareholders as a way of

providing some information about the anticipated effects of hypothetical events.
To give an example, in its 2007 Annual Report and Accounts, Cadbury
Schweppes, the world’s largest confectionery company, includes on p. 46 of its
Financial Review a table showing the expected impact on the income statement
of both a 1% decrease in interest rates and a 10% reduction in the value of
sterling against other currencies. This table gives the reader some idea of its
exposure to interest rate and foreign exchange risk.
Comparison of approaches to Quantification of Risk (Table)

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9. Tools and Techniques to Mitigate Risk
Knowing the potential scale and likelihood of any given financial risk, management needs to
decide how to deal with it. This means deciding whether it wishes to accept, partially
mitigate, or fully avoid the risk. Different tools exist for each of these choices and for each
risk type.
Choosing the most appropriate tool depends upon the risk appetite, level of expertise in the
business, and the cost effectiveness of the particular tool. The board of directors sets the
organization’s risk appetite, so it is important for board members to understand the
methods being used to manage risk in their company. If the methods are not well
understood, then it is advisable not to use them.
Risk Management Tools for Different Categories of Financial Risk (Flow Chart)

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9.1. Market Risk Tools
9.1.1. Internal Strategies
• Natural hedging is internal to a business and takes advantage of the

fact that different risk exposures may offset each other.
Uses: primarily used in managing foreign exchange and interest rate

risks.
• Internal netting: This is a form of natural hedging.
Uses: to manage multiple internal exposures across a range of

currencies.
9.1.2. Risk Sharing Strategies
• Forwards are contracts made today for delivery of an asset at some

specified future date, at a pre-agreed price.
Uses: to protect against possible rises in asset prices – most

commonly either commodities (gas, oil, sugar, cocoa, etc.) or
currencies.
On the agreed delivery date, the buyer takes delivery of the

underlying asset and pays for it. At that date, the buyer has a position
whose value is equal to the difference between the agreed forward
price and the current spot price. Other things being equal, the value
of this position will be positive if the spot price has risen, or negative
if the spot price has fallen. In some cases, forward contracts call for
the buyer to pay or receive, in cash, the difference between the
forward and terminal spot prices. Either way, the forward contract
allows the buyer to lock into the price to be paid, thus protecting the
buyer against the risk that the future spot price of the asset will rise. It
also protects the seller against the risk that the future spot price will
fall.
Forward contracts are tailor-made and traded over-the- counter (OTC)

between any two willing counterparties, each of whom is exposed to
the risk of default by the other on the contract. The forward contracts
therefore create credit risks that the firms concerned need to
manage.
• Futures: Futures contracts are a form of standardized forward

contract that are traded exclusively on organized exchanges.

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Uses: In principle, futures may be used to protect against changes in

any asset or commodity price, interest rate, exchange rate, or any
measurable random variable such as temperature, rainfall, etc.
Contract sizes for futures are standardized, meaning that they lack the
flexibility of forward contracts. Additionally, it is not possible to use
straightforward futures contracts to protect against price changes for
all commodities. For example, jet fuel is not traded on an organized
futures exchange, so airline companies have to find alternative tools,
such as the commodity swap market, to manage their exposure to the
risk of rising fuel costs.
Nonetheless, the protection that futures (and also forwards) provide

can be vital for all commodities that are significant components of
production.
• Joint ventures imply that an organization is willing to accept a given

level of risk, but it may wish to share that risk with another party.
Uses: expansion into new markets where shared knowledge, as well

as shared costs, helps to reduce risks.
The counterparty to any futures contract is the exchange itself. This

means that firms taking futures positions face negligible default risk.
The exchange protects itself against default risk by obliging firms
involved to maintain margin accounts. Every day, the value of the
position is marked to market, and gains or losses are settled
immediately. So, for example, if a firm has a purchased a futures
position (i.e., one that increases in value if the futures price should
rise), and if the futures price does in fact rise, then the firm can take
its profit. But if the futures price should fall, the firm will realize a loss
and may face margin calls. Futures contracts are more liquid than
forward contracts, but the firm also has to take account of the
possibility of margin calls that may strain liquidity.
• Swaps: A swap is a contract to exchange the difference between two

cash flows at one or more agreed future dates.
Uses: management of interest rate and exchange rate risks. More

recently, markets in commodity and credit risk swaps have developed.
Swaps can be used to (a) reduce funding costs, arbitrage tax, or
funding differentials, (b) gain access to new financial markets, and (c)
circumvent regulatory restrictions.

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Many swaps also involve exchanges of cashflows across currencies. An

example of such a cross-currency interest rate swap is where a firm
might convert floating-rate payments in the Canadian dollars into
fixed-rate payments in the US dollars. Another example is a so-called
diff swap in which the counterparties swap, say, Canadian dollar
payments at the Canadian interest rate into Canadian dollar payments
at the US interest rate. Other common swaps are commodity swaps,
where one or more swap legs are tied to a commodity price such as
the price of oil or an agricultural price.
Swaps are highly flexible instruments that are traded OTC, and can be
arranged at low cost compared to most other alternatives, but they
also have disadvantages. Most importantly, as with forwards, the
parties to swap arrangements expose themselves to mutual default
risks, although many ‘credit enhancement’ techniques have evolved
to deal with these exposures.
9.1.3. Risk Transfer Strategies
• Options: An option is a contract that gives the holder

the right (but, unlike forward or futures contracts, not the obligation)
to buy or sell an underlying asset at an agreed price at one or more
specified future dates. The agreed price is known as the strike or
exercise price. An option that involves the right to buy is known as a
call option and one that involves the right to sell is a put option.
Options come in a great variety of forms, and can be exchange-
traded as well as traded OTC.
Options can also be classed as European, American, or Bermudan,

depending upon when the option may be exercised. A European
option gives the holder the right to exercise the option at a fixed
future date; an American option gives the holder the right to exercise
at any time until the date the option expires; and a Bermudan option
gives the holder the right to exercise over some part of the period
until the option expires.
There are many different types of options. Some of the more common
include: caps and floors, in which a price or rate is capped or floored;
Asian options, in which the underlying is an average rather than a spot
price; and barrier options, of which the most important are knock-out
options that automatically become worthless if the underlying hits or
exceeds a stipulated barrier.
Uses:

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o Firms might use caps on interest rates to hedge their

interest rate exposure, or caps and floors on exchange
rates to hedge their foreign exchange rate risk.
o Asian options on fuel prices may be used to hedge fuel bills
(e.g., by airlines), where the main concern is the average
price of fuel over an extended period.
o A firm might purchase an option with a knock-out barrier
on an exchange or interest rate (a) because it is cheaper
than a ‘regular’ option, (b) because it does not expect the
underlying to hit the barrier anyway, or (c) if the firm is
otherwise ‘covered’ should the barrier be breached.
Options give the holder downside protection so that the maximum

possible loss is limited to the premium (or price) of the option. But
they can still get the upside profits if the underlying goes the ‘right’
way. This attractive feature makes options expensive relative to most
other derivatives.
Options are similar in nature to insurance, but although their

functions are similar, an option does not satisfy the legal definition of
insurance. For example, to legally purchase insurance, the purchaser
must have an insurable interest in the property being insured, but
there is no such requirement when purchasing an option.
• Insurance: Many risks, such as risk of loss of or damage to buildings or

contents by fire, are best managed by traditional insurance. The
payment of a premium secures the purchaser against losses on the
insured asset.
The purchase of insurance is often obligatory, either for legal reasons

or as precondition for credit – as is the case with mortgages.
Self-insurance: The firm may decide to bear certain types of risk itself,
and possibly set up its own insurance company (known as a captive
insurance company) to provide the cover. The global accountancy
firms of PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst
and Young, and KPMG are good examples of businesses that own
captive insurance companies that provide the firms with professional
liability protection for their audit staff. Self-insurance is also often
used to cover employee benefits such as health benefits, in addition
to covering certain types of litigation risks, and may be combined with
purchased insurance. Captive insurance companies may retain all of
the insured risk or choose to reinsure a portion of it in the open
market.

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• Securitization: The conversion of financial assets (such as credit cards,

bank loans, and mortgages) or physical assets into financial
instruments that can be traded, often through the use of special-
purpose vehicles.
Uses: creating the potential to increase the scale of business

operations through converting relatively illiquid assets into liquid
ones.
Examples of businesses that have been securitized include airports,

motorway service stations, office accommodation, and utilities. More
recently, firms have begun to securitize the risks associated with their
pension funds.
9.2. Credit Risk Tools

The majority of tools for controlling credit risk fall into this category, including:
• Vetting: prospective counterparties to assess their credit risk. This is

the oldest and most basic means of managing credit risk exposure.
• Position limits: imposing limits on the credit to be granted to any
individual counterparty. These position limits can be both ‘soft’ and
‘hard’; the former would be similar to targets that might occasionally
be breached; the latter would be hard and fast limits that should not
be exceeded under any circumstances.
• Monitoring: Firms should always monitor their ongoing credit risk
exposures, especially to counterparties to whom they are heavily
exposed. Monitoring systems should send warning signals as a
counterparty approaches or breaches a position limit.
• Netting arrangements: to ensure that if one party defaults, the
amounts owed are the net rather than gross amounts.
• Credit enhancement: techniques include periodic settlement of
outstanding debts; imposing margin and collateral requirements, and
arranging to make or receive further collateral payments if one party
suffers a credit downgrade; purchasing credit guarantees from third
parties; and credit triggers (arrangements to terminate contracts if
one party’s credit rating hits a critical level).
• Purchase of a credit guarantee: the purchase from a third party,

usually a bank, of a guarantee of payment. One example is an export
credit guarantee, which is often issued by governments as a way of

Risk Management
encouraging a growth in exports to developing markets in which

credit risks may be relatively high.
• Credit derivatives: these mitigate downside risk by transfer to an
external party. Examples of credit derivatives include:
• Credit default swap: A swap in which one payment leg is contingent
on a specified credit event such as a default or downgrading.
• Total return swap: A swap in which one leg is the total return on a
credit-related reference asset. Total return is defined as the coupon
rate plus capital gain or loss.
• Credit-linked note: A security which includes an embedded credit
default swap. The issuer offers a higher rate of return to the
purchaser, but retains the right not to pay back the par value on
maturity if a specified credit default occurs.
However, credit derivatives come with a large health warning: they

entail their own credit risk because the counter-party may default,
and they can also entail substantial basis risk.
• Credit insurance: Credit insurance works in exactly the same way as

any other form of insurance, whereby premiums are paid for the
purchase of a policy that then pays out in the event of a specified
credit default. Such insurance is, however, likely to be expensive.
9.3. Tools to Manage Financing, Liquidity, and Cash Flow Risks
In times of economic downturn, these types of risk may rise to the fore, as access to
credit tightens or the cost begins to escalate. Standard and Poor’s estimates that a
total of $2,100 billion of European company debt will mature between the end of
2008 and the end of 2011, and companies need to make sure that they have controls
in place to ensure access to the finance and liquidity necessary to sustain trading.
The starting point for managing liquidity and financing is the use of internal controls
to monitor both liquidity and access to funding. Among the tools available for this
purpose are:
• Lines of credit: Arranged in advance with banks and suppliers, these

lines are essential to maintaining the ability to trade by ensuring that
neither liquidity nor access to core inputs is placed at risk. Some credit
lines will include covenants that must be adhered to for credit to
remain available e.g., maintenance of a maximum debt/equity ratio.
• Working capital management: Too much capital tied up in inventory
or accounts receivable puts liquidity pressures on a company, making

Risk Management
it more difficult to take advantage of opportunistic investments.

Additionally, debtors and inventory offer no return on capital. On the
other hand, cash invested elsewhere in a business could be used to
increase earnings. The use of Key Performance Indicators for core
working capital ratios, and investment in MRP systems and other
software can also help to maintain maximum access to short-term
finance.
• Keeping liquid assets: Firms can also protect their ability to trade by
keeping reserves of easily liquidated assets, such as 90-day notes, that
can be liquidated easily and at low cost if the firm needs additional
financing in a hurry.
• Debt/Equity mix: Finance theory suggests that when levels of long-
term debt exceed certain levels, the cost of capital for a business will
increase. So, maintaining an optimal debt/equity mix is vital to
maximizing shareholder wealth. Excessively high ratios also create
risks because it may lead to breaches of borrowing covenants, which
result in additional costs. This risk must, however, be weighed against
the benefit that such debt has a lower cost than equity.
There are no derivatives-based tools available to manage financing and

liquidity risks.
• Liquidity insurance: insurance against a sudden loss of liquidity which,

if not resolved, would endanger a company’s ability to continue
trading.
10. Conclusions
All organizations face financial risks, and their ability to achieve their objectives (and in
some cases even their survival) depends on how well they manage those risks. It is therefore
critical to establish a framework that
(a) facilitates the identification and quantification of the main types of risk to which a firm is
exposed, and (b) sets out the main tools and techniques that the firm will use to manage
those exposures. The importance of financial risk management is reinforced by the very
large losses reported by many institutions since August 2007, which highlight the fact that
they still have a long way to go before they can be said to be managing their financial risks
adequately. Financial risk management does not come cheap, but it is less expensive than
the alternative.

Risk Management
Sources:
• https://catalogimages.wiley.com/images/db/pdf/0471706167.excerpt.pdf
• https://www.cimaglobal.com/Documents/ImportedDocuments/cid_mag_financial_risk_j
an09.pdf
• https://rbidocs.rbi.org.in/rdocs/notification/PDFs/9492.pdf
*******

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Financially Yours

A Primer on Treasury Management

2. What is Risk Management?

• It is the process of assessing threats, taking steps to mitigate risk to an acceptable

Financially Yours 1 Preparation Primers

4. Types of Financial Risks

• EXAMPLE: CADBURY’S SCHWEPPES’ EXPOSURE TO FOREIGN EXCHANGE RATE

The confectionery giant, Cadbury Schweppes, recognized in its 2007 annual

Financially Yours 2 Preparation Primers

• EXAMPLE: AMAZON’S CREDIT RISKS

• EXAMPLE: CREDIT RISK MANAGEMENT IN THE BANK OF AMERICA

• EXAMPLE: A CREDIT TRIGGER

Banks often impose covenants within their lending agreements (e.g., a

Financially Yours 3 Preparation Primers

specified level. As a result, Swisscom AG incurred costs of Swiss Francs 24

• EXAMPLE: HOW NOT TO MANAGE FINANCING RISK: NORTHERN ROCK

The UK bank Northern Rock provides a classic example of a company that

5. Why Manage Financial Risk?

Financially Yours 4 Preparation Primers

6. Risk Management Cycle/Framework

• Risk identification and assessment

Financially Yours 5 Preparation Primers

6.1. Risk Identification and Assessment

6.2. Risk Response

Financially Yours 6 Preparation Primers

6.3. Risks Strategies & Tools

7. Risk Control Implementation

Financially Yours 7 Preparation Primers

7.1. Review of Risk Exposures

8. Quantifying Financial Risks

Three commonly used approaches to quantifying financial risks are regression

8.1. Regression Analysis

Financially Yours 8 Preparation Primers

• EXAMPLE: MICROSOFT’S USE OF VaR TO MANAGE ITS FINANCIAL RISKS

Where companies have global operations that trade across a range of

Financially Yours 9 Preparation Primers

8.3. Scenario Analyses

Another useful approach to quantifying risk involves scenario analyses (sometimes

• “What if the stock market crashed by 20%?”

Financially Yours 10 Preparation Primers

EXAMPLE: NORTHERN ROCK’S LIQUIDITY PROBLEMS

The importance of liquidity-related scenario analyses was highlighted by the fate

EXAMPLE: CADBURY SCHWEPPES’S INTEREST-RATE AND FOREIGN-EXCHANGE

The results of scenario analyses can be reported to shareholders as a way of

Comparison of approaches to Quantification of Risk (Table)

Financially Yours 11 Preparation Primers

9. Tools and Techniques to Mitigate Risk

Financially Yours 12 Preparation Primers

9.1. Market Risk Tools

9.1.1. Internal Strategies

• Natural hedging is internal to a business and takes advantage of the

Uses: primarily used in managing foreign exchange and interest rate

• Internal netting: This is a form of natural hedging.

Uses: to manage multiple internal exposures across a range of

9.1.2. Risk Sharing Strategies

• Forwards are contracts made today for delivery of an asset at some

Uses: to protect against possible rises in asset prices – most

On the agreed delivery date, the buyer takes delivery of the

Forward contracts are tailor-made and traded over-the- counter (OTC)

• Futures: Futures contracts are a form of standardized forward

Financially Yours 13 Preparation Primers

Uses: In principle, futures may be used to protect against changes in

Nonetheless, the protection that futures (and also forwards) provide