Managing Risk: MEASURE – Is it meaningful?
Measurement of risk should quantify the impact of identified risks, which means risk management decisions are performed in line with the business’ risk appetite and commercial objectives.
- Failure to translate an identified risk into a potential P&L and/or cash impact
- Uncertainty of the impact that risk management is having on reducing risk
- Lack of process to monitor ongoing performance of risk management activities
- Lack of transparency on hedging costs charged by hedging counterparties
- Cash flow at risk analysis
- Stress testing and proactive determination of foreign exchange budget rates
- Portfolio risk analysis assessing impact of diversification
- Global subsidiary risk, cash and liquidity management back to centralised treasury
- Impact of refinance interest rate hedging on interest paid and forecasted cash flow
Risk measurement design is critical in ensuring responsiveness to changes in business or market conditions aligned to the risk appetite of the business. In short, there are four key considerations:
- How significant is the source of risk?
- What is the potential worst-case impact?
- How effective are risk management activities in reducing risk?
- Does the reduction in risk produced by risk management activities reduce the residual risk impact to a level that is tolerable on key metrices (eg: cash, P&L, covenants)?
To position the business to answer these questions, the appropriate identification of risk is first required and should be agreed by key stakeholders. Then, the process of accessing relevant data, building appropriate calculations that produce agreed outputs to make decisions needs to be articulated. First building this process in Excel is a great next step ahead of potentially then moving the Excel structure into a more robust treasury risk management system.
Once the process for the measurement of risk can be performed at agreed periodic intervals, the parameters can be put to paper in a policy that ideally gets approval from the Board. From here, the business should seek to make the process of measuring risk faster, more effective and more flexible over time while always being able to resort to the previous holistic process should any additional development encounter material delays or challenges.
Come operation, the hard work should be complete. The calculations for measuring risk and the potential disparity of relevant data (cash flows, financial markets, derivatives, policy parameters) are arguably the most onerous in Treasury. Without the appropriate systems handling this heavy lifting, people are left performing ad hoc, potentially inconsistent and error-ridden calculations with hours spent compiling reports only to repeat the process the following week or month. Getting the measurement workflow right and then optimising the systems to standardise and expedite the process ensures that people are best positioned to perform risk management and develop innovative risk and commercial solutions.
Why the challenge was proving difficult to solve:
- A lack of a clear policy meant that overall hedging requirements were not certain
- The diversity of leveraged option products and current Excel administration processes made isolating overall exposure highly ad hoc and variable, without active consideration of potential downside impact
- The option structures made transaction costs highly non-transparent
Rochford actions to address and correct the problems:
- We input cash flow forecasts and outstanding hedges into a Rochford-built model to isolate and clearly visualise current exposure, taking immediate hedging actions based on prevailing market conditions
- We included scenario analysis to monitor changes in hedging based on movements in foreign exchange spot markets
- By also designing and implementing an updated hedging policy, we simplified the hedge book over future months using FECs aligned to clear required hedge amounts
- A consistent, practical and appropriate product mix is providing heightened clarity on future CoGS commitments, enabling flexibility in sales pricing and forecasted earnings
- Drastic reductions have been achieved in transactional pricing, particularly on option structures, due to Rochford’s product and pricing knowledge and increasing competition amongst dealing counterparties.