by John Holliwell
T here is nothing wrong with risk. It is the lifeblood of business and the test of entrepreneurs and managers. What matters is how you handle risk and the culture in which you operate.
Do you know the risks to which your business is exposed? Which exposures are big enough to worry about? If there is anything you could do to protect against them? What it would cost to reduce or to hedge your risks? Once you have the facts it is decision time. You can choose to do nothing or seek to reduce the exposures or to hedge them in whole or in part. The unforgivable sins are to fail to consider the risks or fail to act on any decisions.
The risk culture of your business is critical and must be established at the most senior level. Above all it calls for honesty. Too often individuals are criticized after the event for taking decisions that, at the time, were in tune with an organization’s perceived appetite for risk.
But it is never easy to set down effective guidelines and the range of exposures for even a simple transaction can be extensive. For example, an exporter needing to borrow to finance a sale in foreign currency may have to consider counterparty credit risk, currency exchange rate risk, funding risk and interest rate risk. The permutations are endless and the costs of hedging transactions to reduce or eliminate every possible exposure could potentially swallow any profit from a deal.
While losses are likely to be quantitative, the potentially infinite number of risk combinations means that the skills needed to make good decisions are usually qualitative. Even a computer programmed to consider every conceivable permutation of risks needs to be told what level of exposure is acceptable. Any program is only as good as the parameters and data fed into it by people who have themselves been conditioned by experience.
But what of the improbable, the wholly unexpected or the never-seen-before? Effective risk management requires thinking the unthinkable. This does not in any way lessen the great value of the many sophisticated risk-management systems available. The problems come if people start to think of them, and the models they are based on, as infallible.
It is also common for the development of control systems to come after any new risk- related products. Be careful not to bet the business until the exposure is known. To be in business you must make decisions involving risk. However sophisticated the tools at your disposal you can never hope to provide for every contingency. But unpleasant surprises should be kept to a minimum.
Ask yourself:
• Can the risks to your business be identified, what forms do they take and are they clearly understood — particularly if you have a portfolio of activities?
• Do you grade the risks faced by your business in a structured way 9 • Do you know the maximum potential liability of each exposure?
• Are decisions being made on the basis of reliable and timely information?
• Are the risks large in relation to the turnover of your business and what impact could they have on your profits and balance sheet?
• Are the exposures diversified or do you have too many eggs in one basket?
• Over what time periods do the risks exist?
• Are the exposures one-offs or are they recurring?
• Do you know enough about the ways in which your exposures can be reduced or hedged and what it would cost including the potential loss of any upside profit?
• Have trading and risk-management functions or decisions been adequately separated?
• Is there a clear differentiation between the actions taken to reduce potential loss by the hedging of exposures and those where you are speculating in the hope of profit?
• Do you have an effective risk-management policy with responsibility at senior executive officer level?
• Is this policy regularly reviewed to identify new and changing exposures? Even on single transactions the risk profile can change over time.
• Who decides whether or not to hedge any exposures?
• Are adequate risk monitoring procedures in place, including those for contingent liabilities? Exposures can change very quickly and you may need to be able to react without delay.
• Are your colleagues and staff risk conscious? They probably attend marketing and customer care meetings but what about risk management meetings? A single sale rarely changes a business’s future but one mismanaged risk can destroy the hard work of years.
• Are the rewards matched to the risks?
• Are the owners of the business happy at the level of exposure or might they prefer a lower risk profile with a potentially reduced return? What is their ‘appetite for risk’?
• What motivates individuals - is the pressure on management and staff, or the way they are remunerated, encouraging them to take unauthorized risks or to cover up their own or colleagues’ mistakes?
• Do management and-staff feel free to ask questions or admit they do not understand?
• Do you regularly update disaster-recovery plans?
• Are you proud of your business’s culture and ethics?
• Do you learn from your mistakes?
The way in which staff are remunerated has become a hotly debated topic, doubtless fueled in part by envy at the large sums paid to some financial market dealers. Whatever the emotions generated, the skills of such people are in demand and they presumably receive what their employers hope they are worth. But it highlights an important risk-management concern, which is whether the interests of the employee and the business necessarily have much in common.
Unless prosecuted for fraud, the risks to any individual who makes a serious mistake are those of their employment, their reputation and any unpaid remuneration. This would be enough to make many people think twice but not necessarily those with whom you may be most concerned. By the very nature of their jobs the dealers and deal-doers in most industries are paid to take risks and to thrive in a fiercely competitive and often hostile environment.
When a business rewards any of its staff on the basis of volume or of risk-generated profits it encourages them to take excessive chances. And if they get it wrong the
gambler s temptation is often to double up and try again. A ‘rogue’ dealer on a losing streak will need to keep increasing the volume or speculative nature of trades if he or she is to have any chance of wiping out an ever-mounting deficit. After all, it is not their money. Even when they derive no direct personal financial benefit from their actions a great deal of damage can be done by employees under pressure to produce results.
As with so much in risk management you may have to accept that a potential risk exists and then take steps to control it. This means ensuring that no single individual or any common-interest group is given enough rope to hang the business. The principles for achieving this are simple enough but are often not carried out in practice. Set limits, monitor exposures, have clear reporting lines, separate the trading ‘front office’ from the administrative and controling ‘back office’ and ensure that everything is subject to ‘two pairs of eyes’.
How many people know and understand what is going on? If an individual is always too busy to take a day off the alarm bells should start ringing. Are they cracking up or covering up? When problems are suspected, colleagues often turn a blind eye because no-one loves a whistle-blower. This is where the culture of a business is so important; senior management should be judged in large measure by its ethical standards. The reputations of organizations without a high moral code are exposed risk. They often end up losing the customers they have let down and being cheated by their own employees.
In an increasingly complex world how do you monitor risks that you may not fully understand? Employing a poacher as gamekeeper may be a good idea, always assuming you can find one willing to give up their former life and rewards. But all too often the pay offered is inadequate and those you can attract are then buried up to their necks with paperwork and kept in the dark as to what is going on. The only thing to be said for this ‘mushroom principle’ is that it provides senior management with a convenient scapegoat when things go wrong.
Responsibility for risk management rests at the top and if the senior executives do not understand what is going on they must find out. It would be nonsense to suggest that they should know every detail of all that is happening in a business but their job is to ensure that adequate systems and controls are put in place.
Ask straightforward questions and if you do not get a straightforward answer then keep on asking until you understand. Replies couched in jargon or with apparent scorn for your ignorance should always arouse suspicion. Most honest people who are on top of their job are only too happy to explain what they do and why. The fear of looking foolish by asking simple questions or admitting you do not understand something is a considerable obstacle to effective risk management. Once again the culture of a business is all important.
Beware the self-deception endemic to bull markets. Just because it has not gone wrong does not mean it is right. Few organizations are immune from the collective mania of a booming economy and many fear being left behind in market share and profits if they do not keep pace with the competition. The voice of caution is then at best an embarrassment and often an obstruction to be removed. With the recession that so often follows the good years another generation learns the old lessons anew and strives to put in place the checks and balances to ensure ‘it will never happen again’.
9 • Risk management
Box 1: A myriad of financial risks - how many does your business face?
Market risk- exposure to adverse change in the price or value of something in which you trade or are holding as an investment. Where market risk is a factor, and especially in volatile markets, the practice of ‘marking to market’ on a regular basis is an important discipline. This involves using current market prices to calculate any profit or loss that has arisen from price movements since the last time you calculated the value of your assets or the cost of meeting your liabilities.
Liquidity risk - where a market does not have the capacity to handle, at least without significant adverse impact on the price, the volume of whatever you are trying to buy or to sell at the time you want to deal. Also, an inability to meet debts when they fall due.
Counterparty (credit) risk- that a counterparty will not honour their obligations to you. If the default occurs before the date when settlement of the underlying transaction is due you may be exposed to the ‘replacement risk’ of having to bear any costs of replacing or canceling the deal, which are often less than the full amount of the transaction.
A potentially greater threat is ‘settlement risk’, which arises when you pay away cash or deliver assets before your counterparty is known to have performed their part of the deal. This exposure is normally for the full amount of the transaction and may exist during the course of a trading day, or last overnight or longer. Political and country risks - never underestimate the potential impact on a business of decisions taken by national and supra-national governments, government agencies and regulatory bodies empowered to control trade or to set prices and industry standards. Their extensive armoury includes taxation, quotas, tariffs and other trade barriers, currency exchange controls and inconvertibility, restrictions on foreign ownership and the repatriation of profits or capital, availability of grants and subsidies, setting interest rates, granting licences and monopolies, nationalization, expropriation and restitution of assets to former owners.
When dealing with an overseas business or with a st‘ate (‘sovereign risk’), you may also need to consider the country’s social and economic stability, its trading practices, customs and ethics, its commercial law - including insolvency - and the effectiveness of its legal system. Just as you normally set limits on your
exposure to every business or individual with which you deal, so there may be a limit to the amount of exposure you will accept relating to any single country.
Currency exchange rate risk-even the major currencies may experience substantial exchange rate movements over relatively short periods of time.
These can alter your balance sheet if you have assets or liabilities ‘domiciled’ in a currency other than that in which you prepare your accounts (‘translation risk’). And they may affect your profit and loss account if the impact is on income or expenditure (‘trading’ or ‘transaction risk’). There may also be longer-term strategic consequences for the value of your business if, for example, rates of exchange settle at levels that fundamentally alter your competitiveness in international markets.
Hedging risk- this occurs when you fail to achieve a satisfactory hedge for your exposure, either because it could not be arranged or as the result of an error. You may also be exposed to ‘basis risk’, where the available hedging instrument closely matches but does not exactly mirror or track the risk being hedged.
Funding risk-a business fails when it cannot pay its debts; how certain are your finances?
Interest rate risk - if you are a borrower or a lender there will be a direct impact from changes in the rates of interest you pay or receive; this may be compounded by exchange rate risk if the amounts are in foreign currency.
Operational risk- a potential ‘catch-all’ that includes human errors or defalcations, loss of documents and records, ineffective systems or controls and security breaches; how often do you consider the ‘disaster scenario’?
Legal, jurisdiction, litigation and documentation risks - including netting agreements and cross-border insolvency. Are your contracts enforceable in the territories where you operate? Which country’s laws regulate individual contracts and the arbitration of disputes? Could a plaintiff take action against you in an overseas court where they have better prospects of success or of higher awards? There is a growing and widespread belief that, whatever goes wrong, someone else must pay. This ‘compensation culture’, whatever its justification or causes, is becoming a big problem for many businesses.
Box 1 continued
Aggregation risk-where a transaction involves more than one market in which problems could be experienced.
Concentration risk- exposure to a high level of risk on any instrument or in any sector; an extension of concentration risk is that to a market dominated by only a small number of firms.
Systemic risk- the supervisor’s nightmare, where problems in one financial institution or market may cross over to others and to other countries in a domino effect, potentially threatening chaos in the global financial markets.
Summary
Risk and the measurement of risk have been consistent themes of Mastering Finance. But how do you ensure it does not get out of control and threaten your business?
While a growing number of computer programs have been developed to aid in monitoring risk in the wake of recent financial scandals, John Holliwell urges managers to remember that these are not infallible. In asking themselves what can go wrong, managers should always consider the wholly unexpected, or ‘never-seen- before’, and think the unthinkable.
This article provides advice on monitoring risks but stresses that responsibility ultimately lies at the top. It concludes with a panel describing the main financial risks, such as political and country risks, hedging and currency risks, funding and interest rate risks and legal, jurisdictional, litigation and documentation risks.
E conomic thought has traditionally regarded the world as a place where agents maximize their gain, subject to a series of constraints. The typical consumer is assumed to be interested in consumption, with more being preferred to less. The key constraint is a budget limitation, which identifies the problem as essentially an economic one where choices have to be made.
At the same time, companies - organizations that are increasingly mere coalitions of individuals with investment opportunities — are viewed as providing profit opportunities for investors. These companies have been characterized as selecting investment opportunities with a single-minded emphasis on expected profit.
Investors can select which companies to invest in, in order to obtain their preferred risk—return trade-off. Therefore, companies have no reason to bundle projects to obtain a particular risk profile because their owners can diversify across businesses to achieve a specific bundle of risk and reward.
Recently, however, this view of the company’s goals and operating mode has changed. Economists have begun to recognize firm-level risk issues as important considerations and have gone on to develop a way of thinking about risk and its place in the firm. In doing so, economic theory has developed positive theories of optimum volatility management. These ideas have developed under the title of financial risk management.
Why do managers of organizations, who are presumed to be working on behalf of the company’s owners, concern themselves with both expected profit and the distribution of firm returns around their expected value? There are four reasons according to academic study:
• managerial self-interest
• the tax structure
• the cost of financial distress
• the existence of capital market imperfections.
In each case, management is shown to be in an environment in which expected profit does not provide sufficient information about a project or investment decision — managers must concern themselves with the variability of returns.
In the first case, the managers are risk averse, even though the shareholders are not. In the other three cases, a feature of the economic environment leads managers to maximize shareholder value by behaving in a risk-averse manner.
The first reason given for risk aversion relates to managers’ self-interest. It is argued that managers have limited ability to diversify their own personal wealth position, which is associated with their company-specific stock holdings and the value of their
earnings in their current employment. They, therefore, prefer stability to volatility because, other things being equal, such stability improves their own position at little or no expense to other stakeholders.
Objections have been offered to this line of reasoning. Some find it unconvincing because it offers no reason for a manager to hedge his or her risk within the company rather than directly in the market. According to this view, managers could enter the financial market to off-set the effect of the close association of their wealth with company performance. By taking a short position in the market, managers could obtain any level of concentration in firm-specific profitability. However, this argument misses at least three important features of the employment relationship.
First, it is probably problematic for senior managers to be seen to divest, or to be systematically diversifying away, investments correlated with company performance. Such a public divestiture would be required to properly hedge management s personal investment profile.
Second, to the extent that some outcomes, defined as financial distress, lead to their employment contracts being terminated, it may be in the best interest of management to constrain firm-level outcomes, so that the future value of their employment earnings is not lost.
Thirdly, arguments in favor of simple expected-profit decisions neglect the fact that management’s abilities are not directly observable. Therefore, observed outcomes may influence owners’ perception of managerial talent. This would, in turn, favor reduced volatility or at least the protection of company profitability from large negative moves. For all, or any one of these reasons, there appears to be ample justification for the view that managers will and should worry about risk.
Beyond managerial motives, firm-level performance and market value may be directly associated with volatility for a number of other reasons.
The first is the nature of the tax code, which both historically and internationally, is not strictly proportional. With a progressive tax structure, income-smoothing reduces the effective tax rate and, therefore, the tax burden shouldered by a company. By reducing the effective long-term average tax rate, activities which reduce the volatility in reported earnings will enhance shareholder value. However, two points are worth mentioning in this context. First, with the advent of more proportional tax schedules, particularly in the US, the arguments here are somewhat mitigated. In fact, one should observe, other things being equal, a decline in the interest in risk management by American businesses over the past decade. No one, however, has suggested that such is the case.
Second, the tax argument rests on reported income not true economic profit. To the extent that generally accepted accounting principles permit tax planning, this argument may favor tax-motivated reporting and more careful management of the difference between the book and market value of profits. Since there is significant discretion in tax reporting, tax consideration may not motivate actual decision-making nearly as much as this theory suggests. However, the argument here is that real economic decisions are affected by the tax code not just their reporting.
Companies may also be concerned about earnings volatility because of the consequences of profits differing greatly from expectations and the implications of such
negative news for corporate viability. To the extent that a financial crisis or bankruptcy is associated with an increase in costs, a company will be forced to recognize this in its behavior. In such cases, it will behave in a risk-averse manner because it is in its best interest to do so.
Numerous studies offer evidence of the cost associated with financial crisis. The first paper dates back to 1977 and presents empirical evidence of very high bankruptcy costs. More recent studies continue to reinforce the importance of these additional burdens on the company.
Expenses associated with bankruptcy proceedings - legal costs and perhaps most importantly the diversion of management attention from creating real economic value - are large and management correctly seeks to avoid them.
As a result, standard corporate finance training frequently refers to the cost of bankruptcy in the analysis of investment decisions. It is also worth noting that this cost is, perhaps, even more important in regulated industries. In these cases, large losses may be associated with the withdrawal of a license or charter and the loss of a monopoly.
The fourth explanation rests on the need for investment at the company level. According to this view, volatility disrupts investment because it forces a business to both reduce the amount of capital devoted to new projects and seek external resources at times of low profitability. However, external financing is more costly than internally generated funds due to capital market imperfections. These may include the transaction costs associated with obtaining external financing, imperfect information in the market about the risk of investment opportunities or the high cost of potential bankruptcy associated with a higher debt burden. These added costs result in underinvestment in low profitability periods.
Put another way, the volatility of profitability causes the company to seek external finance to exploit investment opportunities when profits are low. The cost of such finance is higher than internal funds due to the market’s higher cost structure associated with the factors enumerated above. This, in turn, reduces investment and expected profits.
The cost of volatility is the foregone investment or lowered earnings in each period that the company is forced to seek external funds. Recognizing this, the company embarks upon volatility-reducing strategies, which reduce earnings variability. Hence, risk management is optimal in that it allows the business to obtain the highest expected shareholder value.
Together, the stories work fairly well. Corporate managers are interested in both expected profitability and the risk, or the variability, of reported earnings. This concern is explained by the costs that vary across the range of possible profit figures associated with any given expected performance. Therefore, the company is led to treat the variability of earnings as a variable that it selects, subject to the usual constraints on management. How it proceeds to manage its risk position is dealt with next.
The question is easy enough but the answer is not so easy. Risk management can quickly be divided into three sub-fields of research. While there are overlaps, the questions, answers and open issues vary by area of discussion. It is, therefore, useful to address each of the following questions:
• how should risks be managed?
• what have non-financial companies done by way of risk management?
• how have financial companies addressed the issue?
The three areas can be seen as two separate problems: theory and application. However, in as much as financial company risk management has developed separately, it is useful to treat the application of risk-management techniques in the financial sector as a separate issue.
This first question is the easiest to answer but hard to implement. When a manager is making the decision to further advance his or her own best interests the problem becomes the usual one of portfolio choice.
Projects and/or activities are selected using the standard risk-return trade-off that finance has long promulgated. Projects are selected according to their expected profitability, their variance and the covariance of their returns with other projects within the firm.
On the other hand, if the manager’s concern over risk is due to its effect on overall firm value, as discussed above, then managers must recognize the effect of volatility on market value. This will lead them to alter their decisions and encourage risk management and control. In either case, implementing such a risk-management procedure requires a strategy that includes both risk identification and risk reduction. The former involves an analysis of the drivers of firm performance and the reasons for the volatility in earnings and/or market value. The latter is accomplished through the standard procedures of risk reduction, such as standard diversification procedures, and rules that limit potential extreme downside results.
From theory to practice, we move from the neat realm of concept into the difficult area of implementation. Here, little information exists on the practices employed by non- financial companies. General management practices to dampen the variability of cash flow and/or profitability are not documented in any systematic way.
Nonetheless, it is generally accepted that risk management can be conducted in two ways. Either a business can engage in activities that together result in less volatility than they would exhibit individually or it can use financial transactions to similar effect.
The first approach is to embark upon a diversification strategy in the portfolio of businesses operated by the firm: in short, engage in diversification by conglomerate merger. However, conglomerate activity, while once a popular strategy, has fallen out of favor. Most companies have learned that they do not necessarily have value-added expertise in more than one area and have found it hard to prosper across industry lines. As a result, those concerned about the volatility of earnings have turned to the financial markets. This is because these markets have developed more direct approaches to risk management that transcend the need to invest directly in activities that reduce volatility.
Financial risk management, using financial products such as swaps, options and futures, can accomplish the same ends and has thereby experienced explosive growth. Such derivative products have proved to be an important means of risk trading. The result of such use on shareholder value, however, is still an open question. The popular
Lords White and Hanson: diversification through conglomerate activity, as at Hanson, has gone out of fashion
press has spotlighted the misuse and abuse of derivatives at Procter and Gamble, Metallgesellschaft and Gibson Greetings. Companies are, therefore, concerned that use of derivative products will hit their stock prices. At the very least, it is a public relations problem.
In many respects the story associated with risk management for industrial companies is transferable to their financial counterparts. However, the issue is more complicated for financial companies. These companies deal in financial markets, as principals and agents, and have a long history of both hedging capability and taking positive risk positions. In fact, it could be argued that their franchise involves taking the financial risk from the non-financial sector.
However, taking financial risk does not imply keeping it. As corporate entities, these organizations, like their non-financial counterparts, must deal with the same issues that motivate the rest of the private sector. They are run by managerial talent that must be concerned with risk for their own benefit. They face the same tax structure and are even more concerned by the cost of financial distress.
While it could be argued that regulatory oversight and its implicit guarantee makes them less risk averse, the existence of regulators that charter and sustain the institutions franchise makes risk a real concern. Management, therefore, must find the correct place for risk management in a sector that has both a reason for taking financial risk and reasons for concern over doing so.
It is, therefore, useful to distinguish two ways of delivering financial services. These can be provided either as an agent or as a principal. In the former, risk is borne by the two sides of the transaction, with little remaining with the financial institution that facilitated it. In the latter, risk is absorbed by the financial institution itself because it places its balance sheet between the two sides of the transaction.
The choice between these two techniques seems to depend upon the institution’s value-added or unique expertise in managing the associated risk. For some risks, the institution frequently finds itself absorbing risk associated with its asset services rather than transferring it, while for others the opposite is true.
The latter group, where financial transactions transfer risk to the buyer of assets, is growing more rapidly. As information and transaction costs have declined, the fraction of financial assets held by risk-transferring institutions, such as mutual funds, pension funds and unit trusts, has increased relative to those held in risk-absorbing institutions such as commercial banks and other depositories. This is due to the decline in the returns offered to these institutions to bear such risks.
Nonetheless, balance sheet risk management is still an important issue in the financial sector. Institutions that accept certain types of financial risk, because of their business strategy, require risk control and management procedures. These should involve the same steps and obtain the same results as indicated above. The drivers of uncertainty must be identified and risk-reduction strategies outlined. The distinction here is that the risks are different from those faced by the non-financial sector. Standard bank management texts, however, have long discussions on risk- identification and risk-management strategies. In a recent review of risk techniques and their application in the financial sector, Santomero and Babbel (1997) and Santomero (1997) catalog the procedures used, along with the compromises made along the way.
Where do we go from here?
The fact that risk matters is, perhaps, not news to senior managers. However, the news is that there is a better understanding of why risk matters and how it should be managed. Whether a company is in the manufacturing sector or financial services, it has risks that need to be managed. In today’s business environment no organization is immune from risk and none can be without a risk-management and control process.
To do so, however, requires a risk-management system that measures, controls and monitors these risks. In addition, it must hold accountable all those that are responsible for controlling the complex set of risks that impact upon firm performance.
As a result of financial change and asset innovation, we have begun to develop a deep understanding of how to fashion an appropriate risk-management system. In fact, the implementation of broad risk-management systems has become big business - indeed a growth area of management interest and consulting.
What does such a system involve? As noted above, it begins with a careful identification of the causes of volatility - the factors that lead to variation in performance. Next, the risks that have been so identified must be actively managed. Recent research has shown how this is accomplished by standardized procedures that measure, monitor and limit the risk-taking activity in order to reduce the volatility of performance. Such systems usually include four parts:
• standards and reports, which identify, measure and monitor the factors that cause volatility
• limits and controls on each of the factors and on each member of the organization that adds risk to a company’s performance profile
• guidelines and management recommendations concerning appropriate exposure to these same risks
• accountability and compensation programs that lead mid-level managers to take the process seriously.
While still in the formative stage, such systems have proved valuable to organizations that have implemented them and are rapidly becoming a standard part of the managerial tool kit. This should not be a surprise.
Shareholders care about risk, the stock market cares and, as has been said, so should senior management. The challenge for these managers is to adopt a risk-control system that reduces the volatility of profitability and engenders a risk-control mentality throughout the organization.
Summary
This article looks at the changing view of risk management within companies. In orthodox terms, says Anthony Santomero, managers ought not to be concerned with balancing risk within an organization since the owners of the business - the shareholders - will have balanced their own risk though holding a diversified portfolio of shares. However, managers are concerned to manage risk within their organizations. This can be attributed to a number of factors: managerial self-interest; the tax structure; the costs of financial distress; and imperfections in the capital market.
Santomero argues that managers are right to be concerned about risk since the effect of risk is to produce volatility in market value. The second part of his article deals with how risk should be managed and the steps that non-financial and financial companies have taken to manage risk. It concludes with a number of suggestions for a risk management policy.
Beaver, W.H. and Parker, G., (1995), Risk management, problems and solutions, McGraw Hill, Inc., New York.
Froot, K., Scharfstein, D. and Stein, J., (1994), ‘A framework for risk management’, Harvard Business Review, November.
Herring, R. and Santomero, A.M., (1990), ‘The corporate structure of financial conglomerates’, Journal of Financial Services Research, December.
Oldfield, G. and Santomero, A.M., (1997), ‘The place of risk management in financial institutions’, Sloan Management Review, Summer.
Santomero, A.M. and Babbel, D.F., (1997), Financial markets, instruments, and institutions, Irwin Publishing.
Santomero, A.M. and Babbel, D.F., (1997), ‘Financial risk management by insurers: an analysis of the process’, Journal of Risk and Insurance, June.
Santomero, A.M., (1997), Commercial bank risk management an analysis of the process’, Journal of Financial Services Research, June.
Santomero, A.M., (1995), ‘Financial risk management: the whys and hows’, Financial Markets, Institutions and Investments 4.
Stulz, R., (1996), Rethinking risk management’, Journal of Applied Corporate Finance 9, Fall.
Wharton School, (1994), ‘Survey of derivatives usage among US Non-Financial Firms’.
V alue At Risk (VAR) measures the maximum loss that a portfolio is likely to sustain over a particular period, given specific assumptions about the behavior of security prices. It was developed as an alternative to relying on position limits for monitoring and controlling risks associated with positions held by traders and trading desks. VAR is now applied widely in financial institutions for risk assessment, risk-based capital controls and risk-adjusted performance measurement. Although it is superior to the previous generation of risk management tools, it is far from a panacea even for those applications. Serious conceptual and implementation difficulties must be resolved before VAR can be applied other than perfunctorily. In addition, it relies on information about trades supposedly provided by an organization’s control systems. But recent financial scandals suggest that control systems are the weakest link in the risk management process.
The disciples (and the vendors) of VAR are advocating its use in risk management systems for industrial corporations involved in hedging. Such applications are likely to produce risk measures that are simply inappropriate for corporate risk management.
VAR is not the first portfolio management tool to be applied out of context in the corporate arena. Diversification was, and is, an eminently sensible strategy for individual investors. However, as a corporate strategy, diversification generally does not add value for stockholders.
Risk management for portfoiio managers
VAR measures the exposure of a portfolio to changes in market prices under a specific set of assumptions. For example, suppose that a portfolio manager holds a $100 million domestic government bond portfolio. If the rate of return on that portfolio is normally distributed with a daily standard deviation of one per cent, the loss experienced on any one day will exceed $1.6 million on five days out of every 100 days, so the VAR is $1.6m. VAR is not a unique number. The probability level and time interval (95 per cent and one day in this case) must be selected and assumptions made about the statistical properties of the rate of return on the under-lying portfolio (a normal distri-bution with a daily standard deviation of one per cent in this case). Table 1 lists VAR estimates for alternative probability levels and volatility assumptions for a normal distribution. The choice of the time horizon and the appropriate probability level are a function of the organization’s ability and willingness to bear risk.
For example, choosing a short time
|
Table 1: Val |
3 |
|||
|
Value of portfolio Standard deviation |
= $100m 90% |
Probability 95% |
99% |
|
|
1% |
1.28 |
. 1.64 |
2.33 |
|
|
2% |
2.56 |
3.29 |
4.65 |
|
|
5% |
6.41 |
8.22 |
11.63 |
|
|
10% |
12.82 |
16.45 |
23.26 |
|
|
15% |
19.22 |
24.67 |
34.90 |
|
|
20% |
25.63 |
32.90 |
46.53 |
horizon, such as a day, implies that early warning signals are important, and choosing a high probability, say 99 per cent, implies that losses greater than the VAR can be tolerated only infrequently.
In the simple illustration given in Table 1, the portfolio consisted of only one security, domestic government bonds. Typical portfolios consist of more than one security or asset class. Moreover, when monitoring trading operations, the positions of different traders or trading desks must be aggregated. The portfolio volatility or the volatility of the aggregate trading position is not simply the sum of the volatilities of the component parts - interdependencies (as manifested by correlations) must also be accounted for. Proper risk management techniques recognize that some interdependencies can be risk reducing (as is the case with diversification). By taking advantage of diversification, the exposure of a portfolio of a particular size can be reduced or the size of a portfolio with a given exposure can be increased. Thus, correlations (or lack thereof) between and within asset classes are important components of VAR, but these correlations increase statistical estimation problems considerably. For example, if there are five components (asset classes or trading positions), there are 10 pairwise correlations to estimate; if there are 10 components, there are 45 pairwise correlations to estimate. In general, if there are N components there are N(N-l)/2 separate pairwise correlations. The extract from J.P. Morgan’s disclosure about the VAR of its trading activities takes into account the interdependencies within and across asset classes.
Determining the appropriate statistical assumptions for modelling the volatility of the portfolio is the subject of much research and innovation. Estimation methods fall between two extremes — either the underlying statistical distribution can be represented by a theoretical distribution (typically a normal or lognormal distribution) or a distribution (called the empirical distribution) can be constructed from historical data. Neither method is necessarily superior (either in theory or in practice) and each has its advocates. Once a statistical distribution, either theoretical or empirical, has been selected, probabilities can be associated with potential outcomes. If an empirical distribution approach is employed, the probabilities of occurrences of given magnitudes are estimated directly from that distribution using Monte Carlo analysis or bootstrapping. On the other hand, if rates of return are assumed to follow a normal distribution, 99 per cent of outcomes are less than 2.33 units of standard deviation from the mean. If the mean is close to zero and the standard deviation is two per cent per day, this implies that there is only a one per cent chance that the portfolio will decline by more than 4.66 per cent on any day (or $4.66 million if the portfolio has a market value of $100m). By varying the parameters, various risk preferences or constraints can be accommodated (e.g. for a normal distribution, 90 per cent of the observations are less than 1.28 units of standard deviation from the mean, so if the mean is close to zero and the standard deviation is two per cent per day, there is a 10 per cent chance that the portfolio will decline by more than 2.56 per cent on any day, (or $2.56 million if the bond portfolio has a market value of $100 million).
Even in this, its most elementary form, VAR has severe limitations, resulting from extreme observations, non-stationarity, illiquidity, non-linearities and model risk. Extreme observations occur because many securities experience a higher frequency of extreme outcomes than is predicted by the commonly employed normal distribution, resulting in a VAR estimate that understates the risk of large losses. Some securities, particularly those with embedded options, have very low probabilities of extremely
Extract from J.P. Morgan 1996 Annual Report Discussion of Risk Management Using VAR
The estimation of potential losses that could arise from adverse changes in market conditions is a key element of managing market risk. J.P. Morgan generally employs a value at risk methodology to estimate such potential losses ... The firm’s primary measure of value at risk is referred to as ‘Daily Earnings at Risk’ (DEaR). This measure takes into account numerous variables that may cause a change in the value of our portfolios, including interest rates, foreign exchange rates, securities and commodities prices, and their volatilities, as well as correlations among these variables. Option risks are measured using simulation analysis and other analytical techniques. These methods produce risk measures that are comparable to those generated for non-option positions in trading and investing activities assuming normal market conditions and market liquidity. These estimates also take into account the potential diversification effect of the different positions in each of our portfolios.
On a regular basis, the Corporate Risk Management Group, with support from the financial group, calculates, reviews and updates the historic volatilities and correlations that serve as the basis for these estimates. DEaR measures potential losses that are expected to occur within a 95 per cent confidence level, implying that a loss might exceed DEaR approximately 5 per cent of the time. In estimating DEaR, it is necessary to make assumptions about market behavior. The standard forecast used by J.P. Morgan assumes normal distributions and an adverse market movement of 1.65 standard deviations.
Reprinted with permission. © J. P. Morgan & Co. Inc. 1997.
However, since no single measure can capture all the dimensions of market risk, we supplement DEaR with additional market risk information and tools such as stress testing. Stress tests measure the effect on portfolio values of unusual market movements and are performed on a portfolio and firm-wide basis to help identify potential sensitivities to abnormal events. Stress testing can take several forms, including: simulation analysis; sensitivity analysis, for moves in values of specific key variables such as volatilities and shifts in yield curves; and specific event analysis, for measuring the impact of abnormal market conditions associated with a specific market event. In selected cases, we supplement DEaR with ‘tail risk’ limits (i.e., risk of loss beyond the expected confidence level) for portfolios that are particularly susceptible to extreme market-related valuation losses.
DEaR for our aggregate trading and investing activities across all market risks averaged approximately $31 million and ranged from $24 million to $44 million in 1996. This compares with average DEaR of approximately $26 million and a range from $20 million to $38 million in 1995. Aggregate market risk levels increased in 1996, primarily as a result of higher risk levels in our proprietary investing activities.
|
DEaR (Millions) 1995 |
1996 |
|
|
High |
$31 |
$28 |
|
Low |
$11 |
$13 |
|
Average |
$19 |
$21 |
|
December 31 |
$27 |
$27 |
large losses. Those losses are difficult to capture with theoretical statistical distributions and require a long history to reveal the bad outcome in empirical distributions.
Non-stationarity is a statistical warning that the past is not necessarily a guide to the future. Historical data yield poor predictions about future outcomes if the process generating rates of returns changes due to alterations in the underlying economic situation. Under extreme economic conditions, such as the Gulf War or a currency crisis, historical relationships, especially correlations, may fall apart.
If securities do not trade in highly liquid markets, reliable prices are not available to calculate rates of return. More critically, if there are large adverse price moves, portfolio managers may not be able to sell large quantities of the security without further depressing the price, particularly if other portfolio managers are doing the
same. VAR will underestimate the severity of bad outcomes unless markets are highly liquid.
Some classes of securities, such as exotic asset-backed securities, either trade in illiquid markets or are so new that an adequate historical record of prices does not exist. For these securities, VAR calculations rely on prices derived from models of the relationship between the security and a more fundamental economic variable such as the interest rate. Actual losses may then exceed the theoretical VAR maximum if the model is imprecise, thus introducing another source of risk dubbed ‘model’ risk or ‘mark-to-model’ risk.
Standard VAR calculations do not allow for non-linear relationships; but, for some portfolios, particularly those with embedded options, non-linear relationships are the norm. For example, a two per cent change in the price of a security may cause a portfolio to lose $1 million but a four per cent change may cause it to lose $10m. Non- linearities can be accommodated but only at the expense of additional estimation problems, typically due to model risk.
Despite these limitations, VAR is a useful risk-management tool for portfolio managers and trading desks. Instead of setting position limits for traders to limit the firm’s exposure to unacceptably large losses, VAR allows each trader’s exposure to losses to be restricted directly. Moreover, individual exposures can be aggregated to accurately reflect the exposure of a company by taking correlations into account. VAR is seldom used in isolation and its efficacy should not be judged on a stand-alone basis. For example, VAR is often accompanied by stress testing or scenario analysis - techniques with their own strengths and weaknesses. Even the process of collecting the requisite data for VAR calculations improves risk control in most organizations. A final VAR caveat: unless the internal control system records a firm’s positions accurately, VAR is akin to whistling in the dark. Debacles such as Barings, Daiwa and Sumitomo provide politically expedient rallying calls for better risk management techniques. The use of VAR by those firms, however, would not have deprived us of the fascination associated with those catastrophic losses, because the ‘rogue’ traders allegedly did not disclose their positions to their employers.
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Risk management for corporations
The stereotypical wheat farmer plays a prominent role in hedging examples used in finance textbooks and in marketing material distributed by futures and options exchanges. Rather than bear the price risk associated with this year’s crop, risk-averse farmers rationally enter into forward or futures contracts to lock in a price and reduce the variability of the proceeds from the crop sale. The relevance of those examples for managing risk in a large publicly traded company is dubious. Public corporations are themselves risk-sharing vehicles; and it is difficult to see how risk reduction by the corporation adds value if stockholders can reduce risks on their own account at low cost by, for example, diversifying their investments. Investing in futures and options contracts is, at best, a zero-sum game unless a company’s managers have superior information. And managers with superior information should be trading on that information (pejoratively called speculating), not hedging.
VAR applications in corporate risk management have two drawbacks: VAR does not measure the exposure that is relevant to value-maximizing corporate risk managers; and VAR is misleading in the presence of illiquid assets on corporate balance sheets, especially if accounting rules do not reflect economic reality.
It is well accepted that, in the classic Miller-Modigliam model of the firm, risk management per se does not add value to the firm. Departures from that model reveal that risk management can, under certain conditions, increase the company’s cash flows. Those conditions involve the presence of either progressive corporate tax rates, high expected costs of financial distress or short-term financing constraints. Some would add investor clienteles and management performance systems as additional possibilities. Although these conditions justify corporate risk management they do not justify VAR as a risk management tool. VAR is based on the assumption that the volatility of changes in value is of paramount concern. The volatility of changes in value (of the firm or of the equity) is almost irrelevant in an economically justifiable corporate hedging policy.
Consider first how risk management can add value by smoothing taxable income when tax rates are progressive. Suppose that the first $5 million of profits are taxed at 20 per cent and profits above that level are taxed at 40 per cent. If a firm reports taxable profits of $1 million one year and $7 million the next year, its tax bill will be $2 million on profits of $8m. If adroit use of futures contracts allows managers to smooth taxable income so that $4 million is reported each year, the total tax bill for the two years will be reduced to $1.6m. Similar effects can be demonstrated if tax losses can be carried forward but not backward to earn a refund. Managers who engage in derivatives transactions to reduce income taxes follow strategies to lessen the volatility of reported taxable income and are not concerned about the volatility of changes in the value of the company or of the equity. VAR is uninformative about their strategy.
Alternatively, suppose that the corporate risk management program is designed to reduce the expected cost of financial distress, which depends on the probability of financial distress and the costs of financial distress if it occurs. Financial distress reduces a company’s cash flows if suppliers, employees and customers are not willing to trade with it on the same terms if distress is likely. Apple Computer provides a classic example of distress costs now that its existence is in doubt. Customers are reluctant to buy a durable good, software developers are skittish about investing in products that are specific to Macintosh computers and employees are reluctant to invest in firm- specific skills. If there were financial instruments with pay-offs negatively correlated with Apple’s fortunes, Apple’s stockholders would benefit from lower costs of financial distress if management hedged using those instruments. Unfortunately, other than the stock of Intel and Microsoft, those instruments are not traded and it is difficult for a corporation to sell its own stock short.
Some short-term financing constraints create a role for risk management but, again, VAR has little relevance here, because profit-maximizing managers should focus on reducing the mis-match between cash required for short-term investments and cash available from financing, especially from internal financing. In contrast, for companies with ready access to capital markets (such as those with highly rated debt), it is difficult to see how risk management (particularly interest rate risk management) adds value for stockholders. The intuition behind risk management for financially constrained business is as follows: if cash available from internal and other financing sources falls short of cash required for potentially profitable investment projects in some states (e.g. when oil prices are high), managers can reduce or eliminate the costs of forgoing those projects by investing in financial contracts (for example, oil futures) that pay off when the undesirable states occur. Financial constraints are necessary but not sufficient to create value-maximizing demand for hedging of this kind. It must also
Check the oil: a ‘pure play’ approach allows investors in an airline, for example, to hedge the risks of fuel price fluctuations
be the case that, in bad times, a company’s investment demands do not decline by as much as its available cash flows decline.
For example, consider two firms who face short-term financing constraints and whose fortunes depend heavily on the price of oil: an integrated exploration and production company and a natural resource group that pursues growth by acquisition. The oil producer’s cash flows decline if the price of oil falls but its demand for investments in new oil exploration projects declines also since, at low oil prices, oil exploration is not as profitable. Hedging contracts that pay off if the price of oil falls will not add value since they will produce cash flows when investment demand declines. On the other hand, the natural resource company believes that, when times are bad, acquisitions are more profitable because companies can be bought at ‘fire sale’ prices. Such a company might add value by hedging to ensure that, in otherwise bad times, it has adequate funds to acquire distressed properties. When times are good, the hedging activities will restrict the availability of funds but lucrative acquisitions are then in scarce supply.
A pure play’ argument in favor of hedging is sometimes given. It is argued that some stockholders would prefer to invest in a company’s main line of business but avoid some of the ancillary price risks associated with some inputs or outputs. For example, a pure play airline would allow investors to take only the risk of airline operating and marketing efficiencies by hedging oil price (fuel) risk. Even if there were such a class of investors, hedging to accommodate them would increase firm value only if the company could extract a premium from those investors. The logical and empirical validity of that possibility has not been demonstrated. Some theories of compensating management suggest that better performance measures could be obtained if the effects of some price changes were removed from the measured performance. Why that purging should be achieved with hedging instead of through the accounting system has not been demonstrated.
Of course, there may be managerial incentives to hedge if the ownership of the corporation represents a considerable part of management’s wealth and if the corporate control system allows managers to focus on maximizing their utility rather
Value at risk and hedging: pitfalls for the unwary
than on maximizing the value of the stock. Hedging by these firms does not add value to stockholders, but VAR does not measure the costs imposed on stockholders by the unnecessary hedging behavior.
Even if the VAR concept corresponds with a company’s hedging objectives in a corporate setting, VAR provides little relevant information because, for most non- financial companies, many assets and liabilities are not liquid and accounting rules do not mark even all liquid assets to market. Consequently, VAR tells investors about the exposure of its financial instruments to gain or loss, but not about potential gains or losses for the remainder of the firm’s assets and liabilities. Nevertheless, in 1995, the US Securities and Exchange Commission (SEC) adopted VAR as an acceptable method of providing required information about a company’s derivatives activity. Why information about a subset of a firm’s assets (derivatives) warrants such attention reflects politics, not economics.
These limitations of VAR are mitigated for companies with highly liquid assets and liabilities, such as banks and insurance companies. They are close analogs of the trading companies and portfolios that were the origins of VAR and it is rational for them to reduce the volatility of their capital (assets less liabilities) so that the same capital can support a larger investment base or so that a given size of operations can be financed with less capital. However, even for financial institutions, the presence of illiquid assets or liabilities on balance sheets and accounting rules that do not mark even all liquid assets to market distort incentives if VAR becomes the focus of regulators.
Regulators of banks and financial institutions have embraced VAR as a regulatory tool. The Basle Committee of the Bank of International Settlements (BIS) has proposed that the capital requirement for commercial banks be based on VAR. VAR is defined as the maximum loss that will be incurred over a 10-day period with a 99 per cent probability and capital is then set at three times that VAR. Others who have followed suit in adopting VAR for capital adequacy standards, albeit with different parameters, include: the European Union Capital Adequacy Directive; the International Swaps and Derivatives Association; the Group of Thirty; the Derivatives Product Group; and, in the US, the National Association of Insurance Commissioners.