A company's decision to hedge, and its choice of the most suitable instrument represent the penultimate step in an integrated risk management process. Only a comprehensive, clearly structured process can ensure the safe use of derivatives and thus provide effective support for the operational units. The aim of this article is to provide a summary of the most important components of such a risk management process, see Figure 1.
Risk Policy
All risk management begins with a clearly defined risk policy, setting out the objectives of the company's risk management. This must include statements on the company's risk appetite, the roles of financial and senior management, and the conditions under which those handling risk management can act. The risk policy forms the basis for the whole process, and must therefore be approved and supported by top management.
Risk Analysis
The next step, and the basis for the deliberate management of risks, is risk analysis. This involves defining the risks specific to the company, on the basis of those risks to which the fundamental business is liable. The financial risks deriving from the fundamental business naturally play a particularly important role here. Figure 2 summarizes the most frequent financial risks.
Experience shows that market risks represent the principal elements in the risk structure of a non-bank. These are normally divided into interest rate, currency, commodity, and stock price risks. It is precisely for these risks that security through the use of derivatives is possible and most widespread.
Like banks, non-banks also need to take counterparty risks into account. Credit risks derive from debtor management, when, for example, the sales department offers the customer generous payment terms, or even arranges a credit. However, possibilities for hedging against counterparty risks through credit derivatives are still in their infancy, even in the financial sector. Relatively low volumes are currently recorded for such instruments. Counterparty risks also include replacement and settlement risks.
The third main type of risk is liquidity risk. One aspect here is the minimum liquidity risk--the risk of falling below the minimum level of liquidity required to continue operating. The market liquidity risk, the risk a company is unable to render liquid significant positions in a particular market, for example because it is itself the most important player in the market, is also important.
It is essential to ensure that risk analysis covers the influence of financial risk on the totality of the company's business process. In addition to these purely financial risks described above, other business risks should not be neglected. Organizational risk in particular is regularly revealed as the real starting point of accidents with derivatives.
Risk Measurement
The third step in our risk management process is risk measurement. Before a company can determine an appropriate hedging strategy, the impact of the identified risks on the company's results must be quantified. There is an extensive range of models and methods available for this, though their stage of development varies widely according to the type of risk. One concept for measuring market risk that has become particularly fashionable in recent years, also in corporates, is the value at risk approach.
Risk Management
Now, in the fourth steprisk managementmeasures can be taken within the bandwidths/limits set by top management. These bandwidths are binding on the staff responsible for risk management, and compliance with them is monitored by an independent organizational unit. The purpose of using derivatives is to compensate the losses from identified risk positions by corresponding profits on the instrument providing cover. For this reason, when choosing an appropriate instrument, it is necessary to investigate the correlation between its change in value relative to change in a risk factor and the change in the value of the fundamental risk relative to a change in the same risk factor. In general, derivatives should only be used to the extent they are understood and can be evaluated by all those involved in treasury management, such as the front office, the back office and accounting. Otherwise, lack of understanding of the instrument can even generate additional risk exposure. The company's data processing systems also must be technically able to display the instrument, to support efficient operational usage. There are, of course, a wide range of non-financial measures for hedging against risks, in addition to the use of derivatives, such as choosing a production site in a foreign market, to reduce the exposure to currency risks.
Measuring the performance
The final step in integrated risk management is measuring the performance. This enables the continuous optimization of the process described here, and makes it possible to react quickly and appropriately to changed circumstances.
In conclusion, we may state that if financial derivatives are used within the framework of a risk management process as outlined above, they can provide optimum support for the company's operational units. In the event of an extremely adverse change in the risk factor, the use of derivatives may indeed enable the company's survival. The use of derivatives for hedging within such a framework should certainly not be dismissed as mere speculation, but must today be regarded as one of the most important tasks of modern treasury management.
This week's Learning Curve was written by Jochen Kaduff, a consultant with McKinsey & Companyin Switzerland and Udo Giegerich, a consultant with Coopers & Lybrand, also in Switzerland.
