SIMNYU The Job of the CFO Financial Risk

SIM/NYU The Job of the CFO Financial Risk Management Prof. Ian Giddy New York University

Risk Management is a Process Corporate Risk Management Define Copyright © 2001 Ian H.

Financial Risk Management Why does it matter? l Why and when should we hedge? l What should we hedge? How should we gauge exposure? l l Financial risk management must be tied to the company’s business Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -6

The Case For Hedging Company has special information l Company has special market access l Secure cash for investment opportunities l Reduce potential costs of financial distress, increase debt capacity, and reduce expected taxes Since currency matching reduces the probability of financial distress, it allows the firm to have greater leverage and therefore a greater tax shield. l Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -7

Optimal Capital Structure VALUE OF THE FIRM HEDGING CAN REDUCE COSTS OF FINANCIAL DISTRESS

Hedging, Valuation, Taxes and Financial Distress Copyright © 2001 Ian H. Giddy giddy. org

When Should Firms Hedge? Business risk Financial risk Copyright © 2001 Ian H. Giddy

Which Firms Should Hedge? Characteristics of firms for which financial stress is especially costly: l Firms with: u Products that require after-sale servicing u Products whose quality is difficult to determine in advance u Products with high switching costs u Products that rely on third-party servicing l And firms that have: u High-growth opportunities u Intangible assets like firm-specific human capital u Large excess tax deductions Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -11

What Exposure Should Firms Hedge? l Currency risk u. Transactions u. Translation exposure u. Economic exposure u. Interest Rate Risk u. Commodity Price Risk Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -12

Measuring Market Exposure Defining corporate exposure: “How will my company’s value be affected by market price fluctuations? ” l Types of exposure l u. Transactions u. Balance sheet/portfolio u. Economic l A risk management framework Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -13

How Effective is My Company’s Risk Management? Warning Signs: l l Don’t measure risk No linkage of risk to value No effort to anticipate Lack of business risk policy Copyright © 2001 Ian H. Giddy giddy. org l l Fragmented effort Narrow focus Poor risk communications Lack of an integrated risk assessment framework Financial Risk Management -14

Formalize Risk Management Policy and Control Framework • Develop an outline of a policy statement, or recommend improvements to existing document • Benchmark controls versus best practice using the Group of Thirty Recommendations, Treasury Management Association Guidelines, or accumulated knowledge of appropriate practices Corporate Risk Management Define Measure Manage Monitor • Assess centralization issues related to financial risk management and treasury design Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -15

Identification and Definition of Financial Exposures Goal: To identify significant financial risk exposures and prioritize them in a manner consistent with management's desired risk profile. Translation Exposure, Transaction Exposure, and Economic Exposure • Long-term versus short-term exposure • Intracompany versus third party exposure • Cross currency exposure Absolute Rate Risk, Convexity, Basis or Correlation Risk Price Risk, Basis or Correlation Risk • Short-term liquidity portfolio • Procurement • Investment portfolio • Inventory • Capital markets borrowing • Sales elasticity • Leasing portfolio • Competitive exposures Currency Copyright © 2001 Ian H. Giddy Interest Rate giddy. org Commodity Financial Risk Management -16

Market Risks: Definitions Three Views of Market Price Risk: l Transactions l Balance Sheet/Portfolio

Market Risks: Definitions Three Views of Market Price Risk: l Transactions Exposure l Balance Sheet/Portfolio l Economic risk. Portfolio Exposure Copyright © 2001 Ian H. Giddy giddy. org Economic Exposure Financial Risk Management -18

Transactions Exposure Portfolio Exposure l Economic Exposure Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain date u. Example: If Nokia invoices a NTT of Japan in Japanese yen for a celphone shipment then the firm has Japanese yen exposure and can hedge this by borrowing yen. u. This kind of exposure is readily hedgable using forwards, futures or debt Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -19

But Transactions Exposure Can be Misleading. . . Transactions Exposure Portfolio Exposure Economic Exposure Austin Computer purchases notebook computers in Taiwan for sale in the US. l Austin must pay in NT$. l Should it hedge its anticipated payments for 1996? l Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -20

Transactions Exposure Austin Computer Portfolio Exposure Economic Exposure NT$ Copyright © 2001 Ian H.

Interest Rate Risk: Portfolio Transactions Exposure Portfolio Exposure Economic Exposure Portfolio risk: interest rate fluctuations can affect the value of a bond investment portfolio l Bond price fluctuations will affect the balance sheet l Can be hedged, using duration as a risk/sensitivity measurement tool l Can be hedged with futures, bond options, and swaps. l Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -22

Transactions Exposure Pepsico Pension Portfolio Exposure Assets (each $10 m): u 1 -year E$ deposit u 5 -year, 6% T-note D=4. 6 u 10 -year Strip l What Economic Exposure Pension liabilities: u $10 m 3 years u $10 m 5 years u $10 m 7 years is Pepsico pension fund’s risk? u. Duration of the assets (+ve) u. Duration of the liabilities (-ve) u. Net duration is the risk to be hedged! Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -23

Transactions Exposure Value at Risk: Santos. Bank Portfolio Exposure INSTRUMENT 30 day 90 day 180 day 1 yr 2 yr 3 yr 4 yr 5 yr 7 yr 9 yr 10 yr 15 yr NET TOTAL Copyright © 2001 Ian H. Giddy SANTOSBANK POSITIONS ($1, 250, 000) ($100, 000) $450, 000 $120, 000 $1, 120, 000 $0 $0 Economic Exposure Asset and liability positions for a Brazilian bank’s New York branch. What risk does it face? $0 ($420, 000) $0 $160, 000 $3, 700, 000 giddy. org Financial Risk Management -24

Transactions Exposure BIS: Minimize Value at Risk Portfolio Exposure INSTRUMENT 30 day 90 day 180 day 1 yr 2 yr 3 yr 4 yr 5 yr 7 yr 9 yr 10 yr 15 yr NET TOTAL Economic Exposure SANTOSBANK POSITIONS ($1, 250, 000) ($100, 000) $450, 000 $120, 000 $1, 120, 000 $0 $0 $0 + ($420, 000) $0 $160, 000 $3, 700, 000 = Value-at-Risk Mean Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -25

Transactions Exposure Market Price Risk: Economic Portfolio Exposure Economic Exposure l Economic risk arises from the real business risk of the company, insofar as it is tied to market interest rates, FX, commodity prices l It affects the shareholder value, but may be difficult to quantify l Hedging may require tailored solutions Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -26

Inmet Mining Corp. In 1994 Canadian mining company Inmet bought 48% of Bougrine, a lead & zinc mine in Tunisia. Inmet had to borrow $33 million at a floating rate. Should it hedge its cost of funds? l Answer: Business exposure is to lead & zinc prices (mine shutdown in Oct 96 because of low zinc prices) l Hedge with digital option linking cost of funds to lead & zinc prices l Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -27

Transactions Exposure Market Price Risks: Summary Portfolio Exposure Economic Exposure Three Views of Market Price Risk: l Transactions - lock in forward rate l Portfolios u. Avoid duration mismatching l Minimize Value at Risk l Economic risk - business sensitivity to market prices. Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -28

“Most Important” Objective In Using Derivatives To Hedge Market Value of the Firm 8% Volatility in Cashflow 49% Volatility in Earnings 42% Copyright © 2001 Ian H. Giddy Balance Sheet Accounts 1% giddy. org CIBC Wood Gundy/Wharton 1995 End-User Survey “Most Important” Objective In Using Derivatives To Hedge Financial Risk Management -29

Next Step: Analyze Current Exposure Measurement Techniques Precision of the data Risk Information Sources: Time horizon of the projections • Current trade flow data Frequency of reporting • Portfolio system reports • Accounting information • Budgeted trade flow data • Pricing practices Copyright © 2001 Ian H. Giddy Quantification Adequacy giddy. org Financial Risk Management -30

Corporate Exposure Information Sources Current trade flow data Portfolio system reports Exposure Database Hard Accounting information Budgeted trade flow data Soft Copyright © 2001 Ian H. Giddy Economic exposure estimates giddy. org Financial Risk Management -32

Exposure Database: Example Exposure Database Copyright © 2001 Ian H. Giddy giddy. org Financial

From Data to Analysis Exposure Database Exposure Measurement System Copyright © 2001 Ian H.

A Management-Friendly Report An example is Four. Fifteen™, named after J. P. Morgan's market risk report produced at 4: 15 p. m. each day. l The "4: 15 Report, " a single sheet of paper, summarizes the Daily Earnings at Risk for J. P. Morgan worldwide. Gov't Bonds Zero Cashflow l AUD 1 Mo 3 Mo 6 Mo ($000) RISK Risk. Metricsª USD Base. Vols. & correls. as of May 04, 1995. Portfolio Risk Simulation CAD DKK FFR DEM BEF 15 -200 ITL 20 -30 25 12 Mo NLG ESB SEK CHF GBP JPY 22 XEU USD Total 37 160 - 50 -5 20 -105 - 105 2 Yr 0 3 Yr 0 4 Yr 0 5 Yr 0 7 Yr 0 9 Yr 0 10 Yr 0 15 Yr 0 20 Yr 0 30 Yr Equity 0 0 - 196. 1 -29 54 -145 23 22 -29 262 5 139 5, 048 4265 1383 1820 8516 -347 -6 -83 -451 4181 1383 1876 82 502 - 196. 1 22 23 Int. 59 -122 400 740 Eq. Spot Net FX giddy. org Copyright © 2001 Ian H. Giddy Implied Fx divers. Net -200 5, 350 400 8805 Financial Risk Management -35

Exposure Report: Example Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management

Market Risk Measurement Where are we now? Where do we need to be? Volumetric Duration/ PVof 01 • Notional Amounts Copyright © 2001 Ian H. Giddy Option Sensitivity Measures Simulations Value at Risk • Distribution of • Non-linear risk • Limited market • Linear risk market moves and measures scenarios that measures portfolio values could include • Swap/ bond • Delta, gamma, vega, theta, rho market correlations • Includes market equivalents correlations • No aggregation of • Reprice portfolio risk measures • Parallel and non- • Reprice portfolio • Aggregate risk across asset parallel curve measures within classes or shifts instruments • Aggregate portfolio confidence interval risk per scenario giddy. org Financial Risk Management -37

An Overview of Corporate VAR Business 1 Business 2 Business 3 Transactional Database Portfolio Database Projected Revenues Projected Operating Costs Base rates/ Currency market conditions • • Volatilities Correlations Historical rates/ Discrete scenarios Estimates of Cash Flow Distribution Model 1 Interest Rates Model 2 Mean Equities Model 3 Commodities Model 4 Impact on Earnings Currencies Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -38

Analyze Exposure Management Activities • Multicurrency borrowing/ investing, currency of invoice, & commercially -based hedging techniques Investigate opportunities for natural offsets • Financial instruments such as forwards, futures, swaps and options Evaluate alternative hedging techniques • Expected and out-of-pocket costs, benefits and risks of potential strategies; competitors’ actions Cost/benefit analysis • Accordance with overall corporate policy and acceptable from an accounting and regulatory standpoint, if applicable Strategic alignment Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -39

Corporate Exposure Management: Match Tools to Risks Current trade flow data Hard Inflexible, committed Portfolio system reports Accounting information Budgeted trade flow data Soft Copyright © 2001 Ian H. Giddy Economic exposure estimates giddy. org Flexible, optional Financial Risk Management -40

Most-Used Instruments Hedge Identifiable Exposure 70% 60% 50% 40% 30% 20% Foreign Exchange Interest Rates 10% Commodity 0% Forwards Futures Swaps OTC Exchange Struct. Options Type of Transaction Der. Copyright © 2001 Ian H. Giddy giddy. org Source of Exposure Equity Hybrid Debt 1995 CIBC/Wharton End-User Survey Financial Risk Management -41

Market Views Impact Corporate FX Hedging Decisions 80% Sometimes 70% Frequently 60% 50% 61% 40% 48% 30% 33% 20% 11% 12% Alter the Timing of Hedges Alter the Size of Hedges 0% Copyright © 2001 Ian H. Giddy giddy. org 6% Actively Take Positions Wharton/ CIBC Wood Gundy 1995 End-User Survey: Frequency With Which a “Market View Impacts FX Derivatives Transactions Financial Risk Management -42

Sources of Corporate Financial Risk Uncertain Markets Uncertain Exposures Risk! Mistaken Views Wrong Risk

Monitoring and Control Uncertain Markets • Monitoring implies performance measurement Uncertain Exposures • Performance measurement is the science of attribution • Performance measurement requires a benchmark • Surprises require reassessment and response giddy. org Risk! Wrong methods Corporate Risk Management Define Copyright © 2001 Ian H. Giddy Mistaken Views Measure Manage Monitor Financial Risk Management -47

Evaluate Management Reporting and Risk Management Monitoring Process Senior Management reporting and focused performance measurement are necessary to identify problems with the current risk management strategies Independent Risk Management/ Internal Audit Limits & Benchmarks Exposure Information Copyright © 2001 Ian H. Giddy Financial Product Information giddy. org Financial Risk Management -48

Summary: Corporate Market Risk Management is a Process Corporate Risk Management Define Copyright ©

Ian Giddy Ian H. Giddy NYU Stern School of Business 44 West 4 th Street, New York, NY 10012 Tel 212 -998 -0332; Fax 212 -995 -4233 ian. giddy@nyu. edu http: //www. giddy. org Copyright © 2001 Ian H. Giddy giddy. org Financial Risk Management -53