How Do Firms Manage Financial Risk?

After completing this reading, you should be able to:

  • Compare different strategies a firm can use to manage its risk exposures and explain situations in which a firm would want to use each strategy.
  • Explain the relationship between risk appetite and a firm’s risk management decisions.
  • Evaluate some advantages and disadvantages of hedging risk exposures and explain challenges that can arise when implementing a hedging strategy.
  • Apply appropriate methods to hedge operational and financial risks, including pricing, foreign currency, and interest rate risk.
  • Assess the impact of risk management tools and instruments, including risk limits and derivatives.

Financial institutions are required to manage financial risks. However, it is an uphill task given that risk management should go hand with the firm’s owners’ objectives, the reason for risk management strategy and the type of risks, risks to be retained, and types of instruments available.

The modern risk management follows an iterative road map which involves five key areas:

Identification of the Risk Appetite

This involves taking note of the corporate objectives and risks, and deciding whether to manage risk and in case risks are managed, what type of risks.

Risk Appetite

Risk appetite refers to the types of risk the firm is willing to accommodate. It, however, should be differentiated with the risk capacity, which is the highest level of risk that a firm can handle. Another term is the risk profile, which the current level of risk to which the firm is exposed.risk profile

The practical risk appetite is stated in two ways:

  1. A statement that gives the preparedness of a firm to accommodate risks in wanting to achieve its goals. This is usually an internal document which the board must approve.
  2. The tools in which the risk appetite is related to daily risk management operations of the firm. These include the risk policy of the firm, business lines’ risk statements, and risk limits.

Many financial institutions have developed risk appetite as an essential factor. From the above diagram, the risk appetite of a firm should be below the risk capacity and above the risk profile of the firm. The dotted lined represents the upper and lower levels at which the risk must be reported.

Risk Mapping

The assessment of magnitudes of risks is required after a general policy structure pertaining to risk management has been set up by the board of directors. Concerned officials from the firm should identify the risks affecting their divisions, should record all the assets and liabilities which have exposure to the risks, and should list orders falling in the horizon set for hedging activities. Once the business risk, market risk, credit risk, and risks associated with operations are identified, the management should look into appropriate instruments to hedge the risks. For example, a firm with foreign exchange rate exposure may list all the assets and liabilities, having exposure to the exchange rate on the horizon of hedging policy. It should also list sales and expenses that are exposed to the exchange rate. After this, it can find the appropriate financial instrument to hedge these risks.

Risk Management Strategies

After understanding the firm’s risk appetite and mapping risks, a risk manager can decide the best way to address the risk while prioritizing the most severe and urgent risks. Moreover, risk must put into consideration the cost and the benefits of each risk management strategy. Risk management strategies include:

  • Avoiding the risk: some risks can be managed by avoiding them. For instance, closing down the business unit or changing the business strategy.
  • Retaining the risk: some risks can be accommodated by the company, through insurance.
  • Mitigating the risk: this method involves an attempt to decrease the exposure, frequency, and severity of the risk. A good example is the improvement of a firm’s infrastructure and putting collateral on credit exposure.
  • Transferring the risk: involves transferring some portion of the risk to a third party. Such methods include insurance and the application of the derivatives.

The type of strategy is decided by the senior management, the board, and the risk manager of the firm. The strategy should enable the firm to operate efficiently within the risk appetite.

Now let us turn our attention a little bit on the transfer of risks. The tools of risk transfer (Hedging) include forwards, futures, options, and swaps.

  • Forwards: A forward is structured such that an agreement is reached where a given amount of asset is exchanged at a predetermined price in the future.
  • Futures: A future is a financial agreement that obligates the parties involved to transact an asset at a predetermined future date and price. The buyer must buy, or the seller must sell the underlying asset at the predetermined price, irrespective of the current market price at the expiration date.
  • Options: These are financial instruments that are derivatives that give an investor the right, but not the obligation, to buy or sell a predetermined asset on a specified future date. Examples of the options include call option, put option, exotic option, and swaption.
  • Swap: This is an over-the-counter (OTC) agreement to swap the cash value or the cash flows associated with a business transaction at (until) the maturity of the deal. For example, an interest rate swap involves payment of fixed interest rate on an agreed notional cash amount for a specified period while the other party agrees to pay a variable interest rate.

The type of transfer tool used depends on the desired goals of the firm. For instance, options might be more flexible than the forward contracts—moreover, the trading mechanism of the risk transfer instrument. For example, firms may decide to use either exchange-traded or over-the-counter (OTC) instruments to hedge their risks. Exchange-traded instruments are standardized products with maturities and strikes set in advance while over the counter derivatives are traded by investment banks, among others, and can be tailored to the firm’s needs. The size of the contract, strike, and maturity can all be customized. However, the credit risk is higher for OTC contracts as compared to exchange-traded instruments. A firm should take into account the liquidity and transaction costs related to the instrument that it wants to use for hedging.

Advantages of  Hedging Risk Exposure

Hedging can reduce the cost of capital, reduce cash flow volatility, check liquidity crunch, and improve the debt capacity of a firm. Firms with tight financial constraints might always want to minimize cash flow volatilities to capitalize on growth opportunities. If there are synergistic effects of hedging on the firm’s operation, then it should actively hedge to reduce volatilities that may adversely affect its business. For example, if a firm’s core business is to manufacture using some crop as an input, then it may use futures on the crop to hedge the price of that crop. In so doing, the firm may go about managing its core business rather than worrying about the price fluctuations in the crop.

Disadvantages  of Hedging Risk Exposure

Hedging can only lead to stable earnings for a limited period. Moreover, hedging is costly (for example, an option requires premiums). Hedging might not be appropriate in a diversified portfolio because risk might be diversified away.

Challenges of Implementing Hedging Strategy

A firm risk management team may miscomprehend the type of risk to which it is exposed, incorrectly measuring or mapping the risk, fail to detect variation in market structure or maybe among the rogue traders, is their own.

Moreover, hedging might involve complex derivatives or strategies which can be compromised by certain events such as interest rate movements.

Poor communication concerning the risk management strategy can lead to dire consequences. A hedging program should be well communicated.

Operationalization of Risk Appetite

As mentioned earlier, risk management road-map is iterative. To operationalize the risk appetite, the risk manager evaluates the risk policies, sets the risk limit, and rightsizes the risk management team.

A firm can choose to hedge against volatilities related to its operations. For example, a firm may hedge the cost of an input material required for a firm’s operations. Since this type of hedging can help reduce the risks associated with the firm’s inputs, a firm can concentrate on its core business. It has an impact on the prices of final products and also the scale of products being sold. Hedging currency exposures to reduce risks of losses in exports constitutes an example of hedging risks related to operations. A tomato ketchup company may choose to hedge its exposure to tomato prices so that it may concentrate on the quality and marketing of its ketchup rather than worrying about the losses it may incur if prices of tomatoes were to increase.

Hedging risks related to financial positions can be performed by hedging interest rate risks, interest rate swaps, among others. If the marketplace is assumed to be perfect, then there is no need for such hedging at all because this will not alter the financial health of a firm. However, if hedging is attempted, it would be even for both parties in the hedge, as both will have equal information about the markets. If the market is assumed inefficient, then there can be benefits from hedging to one party in the transaction. The benefits may be from an increase of debt capacity and tax advantage, economies of scale, or by having comparatively better information than individual investors. Firms should essentially hedge their operations, and if they hedge their financial positions, they should be transparent about their policies. So, accepting some form of risk, hedging other risks, and management of costs of hedging to benefit the firm constitute the activities underlying risk management.

Rightsizing Risk Management

When the firm has a clear picture of its objectives in risky areas, it needs to see that the risk management team can come up and execute the approach. That is, risk management should fit its purpose.

Rightsizing of the risk management team ensures that if a firm uses complex risk management instruments, the firm is independent of risk management providers such as investment banks.

Rightsizing also involves making sure that the risk management function has an elaborate accounting treatment, which can be cost or a profit center. Moreover, the firm should also decide whether to proportionally redistribute the cost of risk management to areas where risk management is concerned, depending on the risk culture and appetite of the firm.

Risk Limits

Rightsizing risk management may also involve setting up a risk-limiting system. A good example is the stress, sensitivity, and scenario analysis limits. Scenario analysis limits are linked to determining how bad the situation in a hypothesized worst-case scenario. Stress test concentrates on unique stresses while the sensitivity looks at the sensitivity of the portfolio to variables changes. However, stress, sensitivity, and scenario analysis limits are sophisticated, requires excellent expertise, and in case of scenario analysis is challenging to be sure if all bases are covered.

Value-at-Risk (VaR) limits give an aggregate statistical digit as a limit, but the management can easily misinterpret it. Moreover, it does not indicate the extent of an unfavorable condition in a stressed market.

The Greek limits provide the risk positions of options using Greeks such as delta, gamma, and theta. However, their calculations may be compromised, given the lack of management and independence.

Risk concentration limits can also be used. Recall that the risk concentrations include product and geographical risk concentrations. To set these limits, a risk manager ought to have an expertise in dealing with correlations because capturing correlation risk in a stressed market is a bit challenging.

Risk specific limits involve setting limits concerning specific risk types such as Liquidity ratios for Liquidity risks. On the contrary, these limits are difficult to aggregate and require expert knowledge.

Maturity (gap) limits state the limits of the transactions at maturity at each period. These limits are aimed to decrease the risk associated with large size transactions in a given time frame. However, they are not evident in delivering price risk. Other limits include stop-loss limits and notional limits.

Risk Management Implementation

Risk management involves choosing the right instruments, coming up with the day to day decisions, and establishing oversight authority. Consider risk hedging, for instance.

Access to all relevant information, data, and statistical tools are required to frame a strategy for hedging. The risk management team should know the background of the statistical tools being employed to create hedges. The nature of strategy, i.e., static or dynamic, is an important decision. Static strategies are more of a hedge and forget kind of strategies, where a hedge is placed almost exactly to match the underlying exposure. This hedge remains in place till the exposure ends. Dynamic strategies require more managerial effort and involve a sequence of trades that are used to offset the exposure as nearly as possible. Moreover, dynamic strategies may result in higher transaction costs and require monitoring of positions closely. Proper implementation and communication are the key requirements for the success of any hedging strategy.

The horizon for the hedging position and accounting considerations related to the hedge often has important implications for the way the strategy is planned. Accounting rules require that marked-to-market profit or loss be duly recorded if the position in a derivative and underlying asset are not perfectly matched with regards to dates and quantities. Tax laws vary among countries, and there are differences in tax laws for different derivatives.

Regular Re-evaluation 

Risk management should be regularly re-evaluated to make sure changes in the performance. These include risk appetite, business activities, new instruments, and cost-benefit analysis.

The evaluation of the risk management system is necessary, and an assessment of overall objective realization should be made. Consider and hedging strategy. Hedging refers to the reduction of risk, and it does not imply a profit or a loss. A party that has successfully implemented a hedge may as well run into a loss. For example, if a long forward position on the price of a crop is taken, the realized rate of yield may be higher, thus will implying a loss. Although the hedge was placed to get rid of the volatility in the price, it would not guarantee a profit. A risk manager should be able to manage transaction costs, inclusive of taxes. Thus, the whole risk management process should be limited within the budget constraints set out prior to the hedge being placed. Based on the evaluation, the board of directors may address and change the policies in place and oblige to the regulatory requirements.

Question

Which of the following best describes the risk capacity?

A. The amount of risk the firm is willing to accommodate

B. The total amount of risk that a firm can accommodate without becoming insolvent

C. The current level of risk to which the firm is exposed

D. None of the above

Solution

The correct answer is B.

Recall that, risk capacity is the highest level of risk that a firm can handle. This implies that it is the highest amount of risk a firm can handle without running insolvent.

Option A is incorrect because it describes the risk appetite.

Option C is incorrect because it describes the risk profile of a firm.


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