FINANCIAL RISK MANAGEMENT FRAMEWORK

RISK MANAGEMENT
FRAMEWORK: POLICY AND
HEDGING
Financial Risk Management addresses various factors including
general business risks, exposure to market prices, tolerance for
risk, an organization’s history, and its stakeholders.
Risk Management Policy is a framework that allows an
organization to grow by building decision-making processes. It
communicates what constitutes an acceptable level of risk to
individuals throughout an organization.
Benefits of Risk Management Policy: The policy supports
performance indicators, management incentives, and efficiency. It
also supports the organization’s market views and risk appetite.
RISK MANAGEMENT
FRAMEWORK: POLICY AND
HEDGING
The risk management policy supports financial risk management
and its questions:
• How are we at risk?
• What is an acceptable level of risk?
• How much will it cost to manage risk?
• What are our risk management policies?
• How do we manage risk within our policies?
• How do we communicate information in a timely and accurate
manner?
RISK PROFILE OF AN
ORGANIZATION
 The risk profile is the aggregation of the total portfolio of risks the
organization faces.
 Organizations can have hundreds of risks and thousands of
controls, often having interrelationships with one another. As a
result, filtering the most salient risks becomes challenging.
The risk profile of an organization is unique and depends on
attributes such as risk tolerance, financial position within the
industry, management culture, stakeholders, and the competitive
landscape in which it operates.
RISK PROFILE: EVALUATING
FINANCIAL EXPOSURES
The first step in managing financial risk is to identify the relevant
exposures.
• These can include a variety of risks such as price risk, liquidity risk, and volatility
risk.
 It’s important to separate different types of risks.
• Each type of risk can have a different impact on the business.

 Not All Exposures Are Obvious

• Some risks may not be immediately apparent.
RISK PROFILE: TO HEDGE OR
NOT TO HEDGE
 Whether to hedge or not is a strategic decision that organizations
need to make.
 The decision of what and how much to hedge depends on various
factors such as the nature of the business, the reliability of
forecasts, and management’s assessment of various exposures.
 Without hedging, an organization may be exposed to both
unfavorable and favorable market rate and price changes.
RISK PROFILE: TOLERANCE
FOR RISK
 Risk Tolerance: This is the ability or willingness of an organization
to withstand risk.
 It depends on the organization’s culture, shareholders or stakeholders,
management’s relationship with them, and their understanding of the risks.
 The risk tolerance decision involves determining a reasonable
level of risk commensurate with an appropriate opportunity for
profit or gain.
 Management, shareholders, and employees of all types of
organizations have a stake in risk management.
RISK PROFILE: TOLERANCE
FOR RISK
The risk tolerance of an organization depends on fundamental
cultural issues, as well as the nature of the business and industry:
 The structure of an organization may provide clues about its risk tolerance
 The business of the organization may provide guidance in risk tolerance
 The origins of the business may impact organizational culture for decades
 The characteristics of the stakeholders should be considered
RISK PROFILE: ACCEPTABLE
RISK EXPOSURE
 It’s easy to focus on common risks or recent events, but it’s
important to also consider infrequent events that could have a
major impact.
 Questions to consider when assessing and quantifying acceptable
loss include:
 What is a material individual loss?
 What are the aggregate acceptable losses over a period of time such as one
year?
 What is the maximum amount that the organization can afford to lose?
 Can the organization reduce the potential impact of a maximum loss scenario?
RISK PROFILE: COMPETITIVE
LANDSCAPE
If an organization hedges and its major competitors do not, the
organization may be at a disadvantage if market rates or prices
move favorably.
 The activities of competitors and the market affect the competitive
landscape in several ways, including:
 the propensity of customers to accept risk through rising prices,
 the willingness of vendors to offer fixed-price contracts or dual currency pricing,
 how products are priced,
 where product inputs are sourced,
 alternative inputs to products and sources of inputs,
 commodity components
RISK PROFILE: BOARD AND
MANAGEMENT
 Roles of Management and Board: Management typically
develops the risk management policy, while the board of directors,
as representatives of shareholders, approves it and oversees
management.
 Given the potential for substantial losses, boards are especially
concerned about financial risk management and its implications in
these key areas:
• Policy
• Strategy
• Oversight
RISK PROFILE: BOARD AND
MANAGEMENT
Information requirement: Both the board and management require reliable,
timely, accessible, accurate, and consistently formatted information suited
to different users to make decisions and guide the organization.
With increasingly complex financial products, the board and senior
management must be capable of understanding the implications of
prospective changes to policy or strategy. This includes
• The financial risks being taken by the organization in the course of business
• Planned financial instruments and strategies for managing financial risks
• Risks of any unusual financial instruments or strategies
• Risk measurement methodologies and their relationship to policy
• Understanding of financial risk reporting results
• Implications of acceptable exposure, risk, or loss limits
• Recognition that it might not be possible to quantify potential losses with certainty
RISK MANAGEMENT POLICY
 Risk Management Policy: This is a critical component of the risk
management function. It provides a framework for making
individual decisions and reflects the organization’s perspective on
risk.
 Reasons for Risk Management Policy: to provide a framework for
decision making, to mandate a policy for controlling risk, and to
facilitate the measurement and reporting of risk.
Policy Components: a clear delineation of responsibility for various
risk management tasks, appropriate risk measurement
methodologies, and acceptable limits for risk tolerance.
RISK MANAGEMENT POLICY
 Information Flow: The flow of information from reporting is an
integral part of the risk management process and should be
addressed by the policy.
 Management and the board need enough information to determine whether
responsibilities are being handled appropriately.
 Risk Limits: Limits should be implemented for financial risks,
particularly market and credit risk.
 These might include maximum size of transactions, number of permitted
transactions, and counterparty limits.
 Investment Policy: If the organization has an investment
management operation, the investment policy will include portfolio
and concentration limits.
RISK MANAGEMENT POLICY:
RISK OVERSIGHT
 Risk Oversight: Finance and treasury activities are typically
overseen by senior management and ultimately, the board of
directors.
Independent Risk Management Function: This function typically
reports to senior management and the board of directors. It
provides oversight and independence from the group responsible
for executing strategies.
Independent Risk Oversight Function: The existence of this function
provides management with a level of comfort, answering the
question, “Who is looking after risk management?”
RISK MANAGEMENT POLICY:
HEDGING POLICY
Hedging Policy: This is a subset of a broad risk management policy
that provides clear direction on the organization’s approach to
managing financial risks.
Hedging strategies are not designed to anticipate the market. The
intent is to reduce or eliminate the risks associated with market
fluctuations.
The impact of hedging and its opportunity costs should be
considered, in addition to an assessment of the cost of risk
reduction or mitigation.
RISK MANAGEMENT POLICY:
DERIVATIVE
 A risk management policy should specify what derivative products
(forwards, futures, swaps, options, or a combination of these
strategies) are acceptable.
The policy should clarify whether products can be bought or sold,
particularly with respect to options and related derivatives.
There have been instances where losses due to derivatives usage
have led to publicity and lawsuits. However, avoiding derivatives
altogether may not necessarily be an alternative.
RISK MANAGEMENT POLICY:
HEDGING STRATEGY
SELECTION
 Hedging Decisions: These always involve a trade-off between an
appropriate level of risk and opportunities for gain.
 Alignment with Business Objectives: The hedging strategy should
align with an organization’s business objectives.
 Basis for Hedging Decision: The hedging decision should be based
on business objectives and tolerance for risk, rather than on market
conditions.
 Decision to Hedge Using Forwards or Options: This depends on a
number of factors, including the skills and time availability of the
financial manager, organizational understanding and acceptance of
derivative products, funds available for hedging purposes, the
characteristics of the market being hedged, the type of exposure,
and the expectation of future market rates.
RISK MANAGEMENT POLICY:
HEDGING STRATEGY
SELECTION
A few considerations in hedging products and their uses follow:
• Forwards (including futures) may eliminate the price risk associated with an
exposure, presuming the underlying exposure and product are identical and
there is no basis risk.
• The buyer of an option obtains protection against adverse changes but retains
the ability to gain from favorable changes.
• The seller of an option earns option premium but accepts all obligations
associated with the option.
• Swaps permit organizations to change the payment structure of an asset or
liability.
• Daily price limits are imposed by some futures exchanges.
• Objectives and expectations help determine strategies.
• Credit facilities are required for forwards transacted with a financial institution,
while futures require only margin.
• Purchased options can provide disaster insurance, or protection, when a
market rate moves significantly beyond a comfort level.
RISK MANAGEMENT POLICY:
RISK MEASUREMENT
 Risk Measurement: This is a key aspect of policy and risk
management. It provides an estimation of potential losses, which
can only be quantified with certainty once they are realized.
 Value-at-Risk: Many organizations use a value-at-risk or similar
composite number as a single, all-encompassing measure of risk.
The intent is to provide management and the board with adequate
information and to improve decision making.
Weaknesses of the Approach: There are weaknesses with the
value-at-risk approach that should be understood by management,
the board, and decision makers.
RISK MANAGEMENT POLICY:
REPORTING
 Management reports should provide clear information to senior
management and the board of directors
 It’s important to ensure that users understand the reports they
receive
 Feedback on reports is crucial
 Reports should mark the exposures to market.
 Reports should provide alternative risk measures that allow
readers to understand the potential risks to the organization.