A Taxonomy of Market and Credit Risk

A wide variety of risks could ultimately be characterized, or linked to market risks. For the purposes of this chapter we utilize the following framework for considering these risks.

• Credit Risks
  • Customer credit risk: the risk that a customer cannot or will not pay an obligation or debt, whether it be through financial distress, dishonesty, or for legal reasons.
  • Sovereign risk: the risk that a sovereign, such as the government of a country, imposes an action, regulation, or law that effectively prevents an obligation from becoming fully payable in a timely fashion or else leads to an asset being expropriated in some shape or form.
  • Funding risk: the risk that the corporation itself cannot obtain sufficient funding in a timely fashion or at reasonable cost.
• Market Risks
  • Currency risk: the risk that changes in exchange rates impact the expected cash flows of an entity. Note that currency risk can have a direct effect such as the realized cash flows in the home currency differ from expectations, or indirectly in that expected sales are impacted due to competitive price changes related to exchange rates.
  • Interest rate risk: the risk that changes in interest rates impact the expected cash flows of an entity.
  • Commodity price risk: the risk that changes in commodity prices impact the expected cash flows of an entity.
  • Equity price risk: the risk that changes in equity prices impact the expected cash flows or operating strategies of an entity.
  • Economic risk: the risk that changes in various economic variables such as GDP growth, housing starts, or consumer confidence impact the expected cash flows or operating strategies of an entity.
  • Liquidity risk: the risk that changes in market liquidity dramatically impacts the ability of an organization to facilitate trades or trading strategies in an efficient manner and at reasonable costs due to shifts in market trading activity.

The combination of these risks has far-reaching implications beyond the impact on cash flows. Often the risks have significant correlations or feedback loops. Additionally their visible nature means that both competitors and customers are dealing with them simultaneously in unique or common ways, which can lead to market-wide feedback loops or cause conventional coping strategies to become more difficult to implement due to demand and market-wide liquidity issues.

Credit and market risks directly affect the broader economy and indeed the context of business. The simple perception (accurate or not) of significant changes in any of the above economic variables can have significant implications for a corporate entity as its creditors, shareholders, suppliers, and regulators have their own assessment of how the position of the entity has changed and thus react in their own ways accordingly. A dramatic example of this would be the impact of the credit crunch on the investment banking firm of Bear Stearns. The fears (real or perceived) that Bear Stearns would not be able to meet obligations or secure adequate funding led to customer withdrawal of activity with the firm and instigated the involvement of the Federal Reserve in proactively forcing a merger rescue.

Credit and Market Risk in an ERM Framework

As discussed, credit and market risks have impacts that reach far beyond the cash flows of an organization. Credit and market risks have an impact on the political, legal, and regulatory environment of business. They impact on business and consumer confidence. All of this results in implications for the marketing and operating strategies of an organization.

It is easy, but incorrect to dismiss these risks as a necessary and unavoidable part of doing business. While credit and market risks affect all firms to a greater or lesser extent, there are plenty of examples to illustrate how an organization’s preparedness and response to these issues lead to competitive advantage. A clear example is that of Southwest Airlines, which by proactively and strategically hedging fuel costs, gained a significant cost advantage over competitors that for various reasons (some legitimate, and some dubious) consciously decided not to act on the risk of changing fuel prices.

As credit and market risk impact on the firm’s business environment, relations with stakeholders (including creditors, shareholders, suppliers, employees, regulators, and customers), strategic plans and operating tactics, it is natural and imperative to include these risks into a company’s ERM strategy. Although the nature and character of credit and market risk imply that it is simply the role of the CFO or treasurer to manage, (and indeed that is functionally where the strategies are most likely to be implemented), it is important to have credit and market risks considered, and the impacts on other risks taken into account within an ERM framework. Credit and market risks are not stand-alone risks. They impact on the other risks inherent in an organization, and likewise the specific credit and market risk of a firm are impacted by decisions made in managing the firm as a whole.

The financial risk philosophy of a firm has a direct link to the key strategies of the firm. For example, gold-mining companies tend to fall into two distinct groups: (1) those that hedge the price of gold for all of their expected future production, and (2) those that do not hedge any of their production. A gold company that hedges production is stating to its stakeholders that it is a company that is focusing on mining gold as efficiently as possible, and its success or failure will be based on this principle. A company that does not hedge its gold sales will have its success largely based on movements in the expected future price of gold. Obviously these two groups of companies appeal to very different shareholder groups. Shareholders who purchase gold stocks as a proxy for an investment in gold will prefer investing in those companies that do not hedge production, while investors who do not want gold price risk in their portfolios will prefer investing in companies that fully hedge production. A similar argument can be made for multinational companies that hedge, or do not hedge, their foreign currency exposures.

Credit risk management is also a strategic and an operating principle. For example, many car companies compete by offering generous credit terms. Alternatively, companies use their financing structure (and by implication their corporate credit risk) as a key part of their operating strategy. A low-debt, low-financial leverage policy tends to lead to a higher cost of capital, but with the advantage of decreasing the risk of bankruptcy and increasing financial flexibility, which can often be used to advantage in adverse economic conditions or tight credit market conditions.

It is important to note that credit and market risk decisions must be conscious strategic decisions. Financial theory does not give black-and-white answers to the correct response organizations should take to these risks. Credit and market risk management philosophies and strategies should be consciously decided on in an ERM framework that recognizes their strategic importance and their interrelatedness with other risks.

The Case for Actively Managing Market Risk

There are many strong arguments for actively managing market risk. These arguments include: more predictable cash flows, reduction of financing costs, fiduciary responsibilities, to maintain focus on the core business strategy and operations, and avoidance of uncertainty.¹

The main argument for actively managing market risks is to maintain predictability and consistency of cash flows. Predictability and consistency of cash flows are significant for a variety of reasons. To begin, shareholders and creditors prefer to have more predictable cash flows. Predictability of cash flows aids in operational planning, and forecasting. For companies that require ongoing research, development, or capital expenditures, the stability of cash flows helps to ensure that the necessary investments can be made regardless of economic conditions.

Stability of cash flows aids in the reduction of capital raising costs for two reasons. Not only do creditors and shareholders tend to reward more stable companies with lower costs of capital, but proactive management of market risk also reduces the probability of financial stress, which by itself leads to lower capital costs. Active risk management is also likely to open additional sources of financing such as securitizations, international financings, and structured financings as well as leading to a wider circle of potential investors and creditors, all of which increase liquidity for the firm and lower the cost of capital.

In certain instances the corporation may have an explicit or perceived fiduciary responsibility to manage market risk. Several different legal cases have been brought forward by shareholders claiming that the failure to disclose risk management policies was material information that needed to be disclosed. There have also been legal cases involving public corporations where management and directors were sued for failing to be proactive in market risk management. The basic result of these cases was that although it is not a requirement of management and directors to implement proactive market risk management, it is incumbent on them to make conscious and informed decisions regarding proactive market risk philosophies and strategies.

By proactively and properly managing market risk, management has one less thing to worry about. This allows the management team to focus on implementing core operational strategies without needing to be overly concerned about market events.

Finally, a major reason for market risk management is the certainty factor. Alternatively this could be called the “fear factor” or the “sleep factor.” By knowing that market risk is actively managed, it means that management does not need to unnecessarily worry about market fluctuations.

The Case for Not Actively Managing Market Risk

Perhaps surprisingly there are many reasons for a corporation to not be proactive in managing market risk.² These reasons include: it is costly to do, it may not be in the shareholders’ best interest, and it is difficult to do properly.

There is no debating that market risk management techniques can be costly. The direct costs are the fees (including spreads) that financial institutions charge for providing hedging instruments and strategies. Although forward-type transactions do not involve a premium, they involve a bid-ask spread on the forward price and they also can be costly in terms of upside risk that is foregone in the case of favorable market moves.³ Option-type strategies involve an explicit upfront fee that many managers are reluctant to incur as the cost of the “insurance” is seen to outweigh the potential benefits of the hedge. A second cost of managing market risk is the need for information systems and professional risk managers to manage the positions of what has become an increasingly specialized field of expertise. Finally, a large-scale hedging program increases the complexity of the accounting and reporting requirements.

Reconsider for a moment the earlier example of gold companies that hedge all of their gold production. Investors who invest in gold-mining companies as a proxy for investing in gold do not want these companies to hedge the market price risk of gold. These investors want and expect the share price of these mining companies to fluctuate as gold prices fluctuate, which, of course, will not be the case if the company has hedged all of their gold production.

A related argument against corporate hedging of market risk is that savvy investors are in a better position to understand and manage their personal risk positions. Although this argument is perhaps true for sophisticated investors, it ignores the fact that few individual investors have the knowledge or time to conduct active risk management of their personal portfolios. Additionally it ignores the economies of scale that exist for a corporation in hedging their exposures. However, the argument is quite legitimate in the case of large institutional investors who may actively want to self-manage market risks and have the scale, technology, and capabilities to do so effectively.

The final argument against active risk management is that it is difficult to do properly and effectively. The well-known derivatives and hedging debacles are testament to this line of thinking. Most market risk management strategies involve derivatives that are difficult to understand and price. Additionally, even the simplest of derivatives can have subtle yet significant collateral effects, especially when market prices are volatile or the market is illiquid. As will be seen later in this chapter, there are a myriad number of factors that need to be taken into account and that are difficult to estimate, including the size and timing of the exposure. Ultimately, market risk management is as much an art as it is a science. The fact that market risk management is difficult, however, should not by itself be an excuse for not attempting to understand and manage these risks.

Natural Market Risk Management

Frequently, when market risk management is mentioned it is assumed that it involves the use of some sort of derivative or similarly complicated financial products. However, that does not necessarily need to be the case. Natural- or nonderivative-based risk management involves using operating, marketing, and/or financing strategies that minimize or potentially eliminate the need for a corporation to utilize complicated financial instruments.

The simplest way to hedge naturally is to diversify product lines, diversify geographically (both in terms of operations and in terms of product marketing), and to diversify funding sources as well as the countries of origin and types of funding.

For instance, a company with significant foreign currency exposure in its sales could mitigate some of the exchange exposure by funding in the country of their foreign sales. As foreign currency inflows drop due to currency fluctuations, so would the cash flows required to make interest payments in that same foreign currency. Likewise, increases in interest flows in the foreign currency would be offset somewhat by increased sales receipts due to the same currency changes.

Funding in a foreign country is particularly effective to hedge sovereign risk events such as expropriation. Assuming that debt contracts are appropriately cross-referenced to market disruption events such as currency controls or expropriation, a company can hedge a foreign capital investment in a country with significant sovereign risk by funding in that country. In the case of a sovereign event such as expropriation occurring, the company can at least (again assuming proper legal construction of funding contracts) walk away from its financial obligations. This obviously does not hedge or replace forgone future profits from the affected investment, but it does mean that the company does not suffer the double indignity of not only losing a capital investment but also having to repay the financing that went into it. The fact that a major foreign capital investment is funded with capital from the country of the investment may in some cases prevent an expropriation from occurring by making the sovereign think twice about the political fallout from targeting a company that has cross linkages with domestic investors.

Another simple way to mitigate exchange-rate risk is to diversify globally. Rarely do all currencies move in concert against a given developed country’s currency. Marketing globally also generally opens up name recognition and thus funding potential with foreign investors. This increase in financial flexibility can be a competitive advantage in funding during times of tight market liquidity.

Other types of natural hedges involve passing on costs to customers through cost-plus contracts, as well as backward and forward integration on the supply and value chain. In fact the types of natural hedges available are limited only by the self-imposed operational constraints and management’s willingness to engage in creative ideas.

The central issue with many natural hedges, however, is that they may drag the company out of its operational comfort zone. Additionally, natural hedges are seldom as well-fitted as financial-based hedges such as derivatives. It is wise to remember that financial hedges are never perfect as well.

Another issue with natural hedges is that they are long-term hedges. The time required to put them into place and to have them take effect is often over an entire business cycle—certainly not ideal for a management team that believes it needs to appease investors in each and every quarter.

The Markets as Risk Indicators

The financial markets themselves provide many indications of risks on the horizon. Markets are efficient and effective indicators since they are composed of the collective judgment of a wide group of people who have a strong vested interest in the prices being accurate. Markets are composed of long-term investors, short-term speculators, consumers and suppliers of commodities and currencies, borrowers and lenders, as well as hedgers, central banks, and arbitragers. Each of these groups has a vested interest in profiting either directly or indirectly (through, for example, buying commodities and manufacturing them into higher value finished goods). Thus, the markets reflect the balance of the supply and demand for goods, currencies, and borrowing, the balance between the short- and long-term views of investors, and the actions of the arbitragers, regulators, and central banks that step in whenever the markets are perceived as out of balance.

The stock market is often quoted as a primary leading indicator of the future performance of the economy. Although major indices such as the S&P 500 give a broad indication of investors’ projections for the future health of the economy, single stock prices can give indications of the future fortunes of an individual firm.

A second primary indicator in the markets is the publicly traded futures markets. Futures markets provide the prices at which investors, hedgers, and speculators are willing to trade commodities, interest rates, and currencies at a given time in the future. While futures prices are not perfect indicators of actual realized prices in the future, the quoted prices are generally considered to be one of the best indicators and are also considered to be unbiased in the sense that they will equally overstate and understate price changes.

Volatility of prices in the financial markets gives information about the level of uncertainty. The higher the volatility of the markets, the higher the level of uncertainty. A commonly followed index is the VIX, a daily index compiled and published by the Chicago Board of Options Exchange (CBOE). The VIX is an index that is composed by measuring the implied volatility that is implicit in the prices of equity options traded on the exchange. A high level of the VIX implied that investors are uncertain of the future direction of price changes.⁵

Volatility of market prices is measured by taking the standard deviation of market prices. A second related measure that is important for risk management is to measure the correlation of price changes. The correlation of price changes is just as important—if not more important—than the volatility in individual prices. Market prices are all interrelated to one extent or another. For example, oil prices tend to be correlated with equity prices and equity prices tend to be correlated with interest rates. Thus, examining risks in isolation can provide a distorted or even a misleading picture of the effect on an organization.

A frequently cited problem with using market data to calculate the potential impact of risks is that markets tend to be unstable. Indeed an examination of volatility levels and correlations can show large changes in relatively short periods of time.

A related technique that some companies use to measure the impact of outside forces comes from the developing field of prediction markets. Prediction markets have been in use for many years as a way to gauge elections. In a prediction market, participants buy “shares” in the future value or outcome of a variable. For example, a prediction market can be set up to predict the outcome of an election by having the shareholders who own shares in the winning candidate receive $1 for each share they own if that candidate wins. If the shares for candidate A sell for $0.63, and for candidates B and C for $0.22 and $0.15, respectively, then the prediction market is indicating that the probability of Candidate A winning is 63 percent, while the probabilities of candidates B and C winning are 22 percent and 15 percent, respectively.

A company can set up a prediction market to predict the demand for a given product by selling shares that represent various levels of demand in the future. The shares that trade among the participants at the highest prices are then taken as the most likely levels of demand to occur. Trading in a prediction market is allowed to take place at several different times. For instance, if a company wanted to predict the level of demand two years hence, it could issue “shares” with each share representing a different level of demand. Participants in the prediction market would then meet at a regular time (perhaps weekly) for a series of two months, with the market being considered closed at the end of the eight trading periods. The level of demand for which the shares were trading at the highest price would represent the most probable level of demand two years into the future. The company could then base its operational plans on this level of demand. Prediction markets have been shown to be surprisingly accurate, and generally better than using the predictions of experts, even when the participants in the prediction market are not all that well informed or knowledgeable about the field for which they are making a prediction.⁶

Measuring Potential Impact

Following the volatility and correlations of market prices and futures prices gives an indication of the direction of prices and how much they have the potential to change in a given period of time. The next step is to measure the effect of those price changes on the organization. It is key to determine whether the impact desired is the impact on earnings or the impact on cash flows, which may or may not be highly correlated to each other. Although financial theory suggests that cash flows are the more significant variable to manage, the publication of a firm’s earnings are more widespread and, thus, the metric that is most closely followed by investors and the metric by which managers are most often compensated. Creditors, however, are more likely to be concerned about the impact of risks on cash flows.

A primary method to measure the impact on a firm is to run a regression of earnings against the price changes of various market variables. For instance, a company that has two commodity inputs and sells in two different currencies might run the following regression of quarterly earnings versus percent changes in each of the two currencies and percent changes in the two commodity prices:

(14.1)

In the above equation E_t is the percentage growth of earnings in time period t, while CA_t, CB_t, FXA_t, and FXB_t are the percentage changes in the price of commodity A, commodity B, exchange rate A, and exchange rate B for time period t respectively. (A and ε_t are an intercept and error term, respectively.)

When compiling the above equation one has to be careful because correlation among the variables can lead to inaccurate and misleading conclusions from the regression. For instance, a strong correlation may exist between a currency and a commodity in the regression. If the correlation is not accounted for, the regression results will be skewed, leading one to believe that one of the critical variables is not significant or vice versa. A second problem with performing a regression is the amount of data needed to get reliable results. Generally, upward of 10 years of quarterly data is needed before statistically significant results are obtained. Depending on the industry, economic relationships that existed 5 to 10 years ago may or may not still be relevant when looking at the next five years for risk management purposes.

Earnings at Risk

When the size of the potential move in market prices has been determined, and the effect of a move on market prices on the firm has also been calculated, then the two can be combined into a measure called Earnings at Risk. Earnings at Risk (EAR) is the corporate application of Value at Risk (VAR), which is used to measure potential losses in investment management and financial institutions. EAR is the most negative level of earnings that a corporation is expected to have with a given level of confidence. For instance, the EAR for a publicly traded company might be a negative $3.50 per share with 95 percent confidence. In other words, this EAR measure is saying that 95 percent of the time the earnings of the corporation will be better than a negative $3.50.

The full details of calculating the EAR are beyond the scope of this chapter. The basic process, however, is to measure the potential range of movements of market variables by measuring the standard deviation and correlations of market movements as described in the previous section. The impact of changes in market prices on the components of a firm’s earnings, such as the impact on the firm’s sales, expenses, interest expenses, and such is modeled. Then the firm’s earnings are modeled using Monte Carlo simulation techniques and the distribution of the firm’s potential earnings are calculated and usually presented in the form of a histogram as shown in Exhibit 14.1. The EAR is the value that corresponds to the leftmost area of the curve. The probability that the realized earnings of the company will be greater than the EAR is the area under the distribution to the right of the EAR level. Equivalently, we can state that the probability of the realized earnings of the company being below the EAR will be equal to the area under the curve in the “left-tail” of the distribution.

The EAR is a powerful and useful risk management tool. The management team can rerun the simulation, remodeling the firm assuming that certain risk management actions had been implemented so managers can compare the distribution of earnings given one risk management strategy versus a different strategy. A simulation obviously does not provide an answer to what will actually happen in the future, but it does provide a reasonable estimate of the range and the probabilities of possible outcomes.

There are also several drawbacks to utilizing Earnings at Risk. To begin, the technique is relatively complicated to calculate. Not only does it require knowledge of Monte Carlo simulation techniques, it also requires the firm to understand how each of the economic variables impacts the firm’s results. These relationships are needed to build an accurate model. An inaccurate model will produce results that will not only be inaccurate but also misleading. It can also be argued that the insight gained from forcing the organization to understand how the income statement can be modeled from economic variables is a useful exercise in its own right for the management to carry out, whether or not it plans to conduct a Monte Carlo analysis for the purposes of calculating an EAR value.⁷

Market Risk Management with Option-Type Products

An advantage of using options to hedge market risk exposure is that options allow the hedging company to profit from favorable moves in market prices or rates. There are two main types of options; call options provide the buyer of the option the right but not the obligation to buy at a preset price and at a preset time for a given notional amount, while a put option gives the option buyer the right but not the obligation to sell. Options are asymmetric instruments as the buyer of the option has the choice to transact, while the seller of the option must transact if the buyer chooses to do so. Therefore, the buyer of the option will only exercise his right to transact when market prices are at the buyer’s advantage to do so. To have this right, the buyer of the option must pay a fee called the option premium to the seller of the option. Therefore, option transactions involve the payment of an upfront fee, and for this reason many companies prefer to hedge with futures that do not involve an upfront fee.

The premium paid for an option is a function of several variables, including the current spot price of the asset, the time to maturity of the option, the value of any benefits or costs of owning the underlying asset in the interim, the rate of interest, the price at which the buyer has the right to transact (called the strike price or exercise price), and finally the volatility of the underlying asset. Option pricing is complex, but there is a well-known formula called the Black-Scholes Option Pricing Model that is frequently used for pricing. All of the option-pricing variables are either part of the option contract (e.g., time to maturity, strike price), or easily observable or known in the market (the interest rate, costs, and benefits of owning the underlying asset). The only variable that is not known or easily observable is the volatility of the underlying asset. This volatility is technically the future volatility of the asset over the lifespan of the option. If the option price is known, the Black-Scholes Option Pricing Model can be solved for the “implied volatility” using the other known pricing variables. The implied volatility as calculated from observed market prices for options is a key method for determining the market’s perception of the level of uncertainty in future market prices.

Options are also traded on exchanges and in the over-the-counter market. Options trade on virtually all of the asset classes that futures do. Additionally, options are available on individual stocks and bonds.

Although options involve an upfront premium, there are many advantages of using options. As previously mentioned, options allow the hedger to profit if market variables move in her favor. Return to the example of a company that needs to hedge the expected receipt of 200,000 euros in six months. The company could buy an option to sell the euros at a strike price of 1 Euro to 1.40 USD. The company would pay a premium for this, but it would be protected if the euro depreciated to 1 euro to 1.25 USD. The payoff from the option in this case would be 200,000 times 0.15 USD or 30,000 USD, which would compensate the company for the fall in value of the euro. However, if the euro appreciated to 1.74 USD, then the company would not exercise its option to sell euros at 1.40 USD, and instead would profit from selling the euros at the higher market price of 1.74.

A second advantage of using options is that the basis risk of being over-hedged or under-hedged, although not eliminated, is at least reduced. For example, if the company is over-hedged and it bought an option to sell 200,000 euros for USD, and it only received 170,000 euros, then it would not have to exercise the option and buy additional euros if the value of the euro appreciated. However, it would have paid more in extra premium for the larger size of the trade.

Multiperiod options such as caps, which provide a payout whenever the interest rate goes above the preset cap rate, work in much the same way. In other words, a company that hedges its interest rate payments with a cap will profit for those periods in which interest rates fall, but receive compensating cap payments for those periods where the interest rates go above the cap rate.

There is a large variety of options called exotic options. Exotic options are options that have specific payout functions. For example, Asian options are options where the payout is based on the average price over a period of time rather than the price at a specific point in time. Take, for instance, a company that purchases oil on the first day of every month. The company risk manager may decide to purchase an Asian option where the payout is based on the average of prices paid over the course of the year as the average yearly cost is more relevant than the cost at a given point in time.

Another type of exotic option is called a basket option. A basket option is an option that has a payout based on the average price of a basket of variables. A risk manager for a U.S.-domiciled company that sells in euros, yen, and pounds may structure a basket option where the payout is based on the average exchange rate achieved among the three currencies. Therefore, if two of the currencies decrease in value versus the USD, but the other currency increases, then the size of the payout will be reduced to the extent that the increasing currency offsets the two decreasing currencies. However, the cost of the premium will also be lower to reflect the probability of this occurrence.

There are many different types of exotic options. The general characteristic of exotic options is that they generally have lower premiums, but correspondingly their payouts tend to be lower as they relate to specific risk scenarios.⁸ If the risk manager has a specific hedge he is trying to achieve (such as the average cost paid for fuel over the cycle of a year, or the net domestic currency proceeds received from a variety of foreign currencies) as in the above examples, then exotic options may be preferable to conventional option strategies. The disadvantage of exotic options is that they can be difficult to understand and difficult to price.

Trade-Offs Between Option Strategies and Forward Strategies

A constant concern of companies is deciding what the optimal strategy is when it comes to market-risk hedging. The short answer is that there is not an optimal strategy that with hindsight is always best. Consider the following simple example. Assume that a company needs to buy a single barrel of oil in three months’ time and that the current price of oil is $100. Ignoring storage costs and the time value of money, we can also assume that the forward price of a three-month forward is also $100 a barrel. Finally, assume that the cost of a three-month call option on oil with a strike price of $100 is $15. If the price of oil in three months is above $100 a barrel, then the company will have preferred to have bought the forward contract. Conversely, if the price of oil is below $100 in three months then it would have preferred to do nothing and simply buy the oil in the spot market. Using a reference point of $100 per barrel, the following table gives the upside and downside for the three different strategies of (1) not hedging and waiting to buy in the spot market, (2) buying the forward contract at the forward price of $100, and (3) buying a call option with a strike price of $100 and a premium of $15.

For instance, if the price of oil falls to $75, the company will have a benefit of buying cheaper oil and saving $25 from the reference price of $100 if the company decided not to hedge and to buy in the spot market. Likewise, the company will be forced to buy at the higher price of $100 if it entered into the forward market and thus it will regret buying the forward by the amount of $25. If the company chose to hedge by buying a call option, it will save $25 on buying the oil in the spot market for $75, but since it paid $15 for the option the net advantage is $10. See Exhibit 14.2.

As Exhibit 14.2 shows, the “Do Nothing, Buy in the Spot Market” strategy has the same payoffs as the “Buy Forward” strategy except in reverse order depending on the realized future price of oil. The “Buy Call Option” strategy, however, is always the second best choice by the amount of the premium paid. The Buy Forward strategy locks in a price but does not allow the company to profit from favorable price moves, and thus carries a potential opportunity risk. The Do Nothing, Buy in Spot Market strategy allows the company to benefit from favorable price moves but does not protect against adverse market moves. The Buy Option Strategy protects the company against adverse price moves, and also allows the company to take advantage of favorable price moves but involves the payment of an upfront premium that could be costly if the price does not move significantly in either direction. Thus, the only conclusion that one can draw is that there is no optimal strategy when viewed with hindsight, but one can state that the option strategy will always be the same as the best strategy minus the cost of the premium paid.

Operational Issues of Using Derivatives

There are a variety of operational issues that a company needs to be aware of when hedging a position with derivatives. Conceptually, derivatives are easy instruments to understand, although in practice things can be much more complicated. Derivatives are subtle instruments and are highly dependent on their specific structural features that are described in their documentation. Additionally, the valuation and accounting for derivatives is a specialized field requiring significant expertise.

A main operational issue with derivatives is the documentation and how it affects the relationship between the company and its financial institution counterparty. The documentation of derivatives is generally done under an International Swaps and Derivatives Association (ISDA) Master Agreement, as well as a Trade Confirmation.⁹ The ISDA Master Agreement is a document that is negotiated between the legal representatives for the financial institution and the company. The ISDA Master Agreement specifies all of the terms that might come up in the life of a generic trade between the two counterparties. These issues would include how payments are to be handled and how day counts for calculating interest are to be defined. Additionally, it will contain definitions as to how payments are to be calculated and how issues such as the payments falling on a holiday are to be handled. When creating the documentation, it is wise to remember that derivatives are being used mainly for hedging purposes, and that the hedges are going to be most needed when extreme and unexpected market events happen. Thus, the documentation has to be valid, reasonable, and incorporate all known possible types of normal and extreme events. The ISDA Master Agreement is a standard template that has stood the test of time, and banks along with their corporate counterparties find it easiest to start with the standard ISDA template when negotiating their own contracts.

Once the ISDA Master Agreement has been completed between the two counterparties, each individual trade will be further documented with a Confirmation. The Confirmation spells out the details for each individual transaction such as the notional size, time to maturity, and strike prices and will make reference to, and be governed under the Master Agreement. It is critical that the Confirmations be executed by someone who not only understands the legal language used, but also understands what the purpose of the trade is and how the trade is supposed to function in different market conditions. Frequently, derivative Confirmations are checked by legal departments that understand the legal language but do not always fully understand the underlying purpose of the trade. Conversely, the risk managers understand how the trade is supposed to work but do not always fully understand how that should be expressed in legal language. The problem is compounded by the fact that the documentation is usually drafted by the financial institution, which, of course, has a vested interest in making sure its interests are most strongly covered.

When choosing counterparties for hedging transactions, it is important to focus on more than just the price at which they are offering the trades. Although getting a fair price at inception of the trade is important, it is also important to have a counterparty that will provide fair prices and liquidity throughout the life of a transaction. Frequently, a company will wish to unwind a hedging transaction because of changes in its operations or changes in the nature of its activities. Therefore, it is essential that the company be able to unwind its hedges in a timely manner and at a reasonable value.

A company should also choose its hedge counterparties based on the quality and amount of advice that each of its counterparties provide. Financial institutions spend a lot of money and time hiring and training its derivatives personnel and counterparties should make use of that talent to the greatest extent possible.

One of the key services that financial institutions provide for its clients is periodic valuations. These valuations should be based on prices at which the financial institution would be willing to unwind the trade. These valuations are important for the company to know accurately. A comparison of the value of the hedge transactions versus the value of the risk exposure should be done on a regular basis to check the effectiveness of the hedging strategy and in order to change the hedging strategy if necessary.

When collecting valuations on existing trades, or for generating prices for potential transactions, it is wise to utilize a variety of sources to ensure fairness and independence of the valuations. A general rule is to secure quotes from three different financial institutions, and to check the reasonableness of each quote versus a similar exchange traded instrument. When soliciting quotes it is always best to ask for both the bid and the ask side of the trade (i.e., the price at which you could buy or sell the instrument). This prevents the pricing source from biasing the answer in order to increase their potential profit.

Governance and Oversight of Market Risk Management

The well-known debacles of companies getting into trouble with its risk management strategies and uses of derivatives highlights the need for companies to have strong and knowledgeable oversight of its risk management function and operations. Risk management and the use of derivatives can become quite complex. Often, organizations try to fine-tune its market risk management positions and in the process make them unnecessarily complex. This can rapidly lead to problems as inexperienced staff try to implement an overly complex and burdensome strategy. Another issue is that companies attempt to use its risk management practices as profit-generating activities. Although it is true that some companies have generated significant profits from taking positions using derivatives—in essence attempting to profit from over-hedging its market risk exposures—the use of this practice is highly questionable from a prudent risk management point of view. Unlike financial institutions, operating companies are not in business to profit from taking on market risk. The use of risk management techniques for trading profit has created significant concern from shareholders and has often prompted boards of directors (referred to as board) to take a knowledgeable and firm stance on the issue.

Many studies and publications have been produced to help shareholders and boards in their decisions regarding the implementation of market risk management strategies.¹⁰ The central theme is that the board and management need to set the tone for risk management and strictly maintain oversight to ensure that policies and the spirit of those policies are followed.

At a minimum the board should set a risk philosophy that states clearly whether the firm will engage in hedging activities, and if so, if the firm will intentionally engage in hedging activities with an intention to profit from the trading. The board also needs to ensure that senior management and the risk management team have the knowledge and the necessary tools to successfully implement and maintain the given strategy. Additionally, the board needs to frequently assess the success of the risk management strategy and reaffirm that the necessary controls are in place.

Before implementing a specific hedging transaction involving derivatives, there are five questions that the risk manager should ask:

1. What risk does the product hedge?

   Although this sounds like a trivial question, it is quite often the case that a hedge will be put in place that does not directly correspond to a known or projected risk.

2. Will the hedge be effective?

   Again, this sounds like a fundamental question, but many of the more complex hedges that are implemented to reduce risks cease to become effective when extreme market events occur. Of course, this is when the effectiveness of the hedge is most necessary.

3. How will the hedge react when stress tested in different economic environments?

   This is of particular concern when cross hedges or correlations between hedges are involved.

4. Does the hedge transaction fit with your view of the markets and the corporate strategy?

   It is obviously important that the hedge strategy does not counteract the corporate strategy.

5. Is the hedge instrument manageable?

   Does the risk management team have the knowledge, the financial analysis tools and data necessary to properly evaluate and maintain the transaction?

Derivatives can aid a corporation greatly in the achievement of its goals. It is incumbent on management to utilize these financial tools in an effective and prudent manner. A poorly implemented risk management strategy will reflect poorly not only on the risk managers, but also on the senior management and the board of directors of the firm.