An introduction to risk management and derivatives

 

INTRODUCTION

Themanagementofriskexposuresisanimportantpartofmanagingabusiness.Itmaywellbeargued that the effective management of risk is essential to the long-term survival of an organisation. An organisationwiththebestproductsorservicesmaystillfailifriskexposuresareignored.Theworld markets are littered with examples of high-profile businesses that have failed because the board of directorsdidnotestablishadequateriskmanagementobjectivesandpolicies,ormanagementdidnot implementandmonitoradequateriskmanagementproceduresandstrategies.

Abusinessmustidentify,measureandmanagethewiderangeofriskstowhichitisexposed. Someriskexposureswillbecommontomostbusinessorganisations;otherswillvarydependingonthe natureandstructureofthebusiness.Thecommontypesofriskexposureswillalsovaryintheextent ofthatexposure.Forexample,mostbusinessesareexposedtointerestraterisk.However,theextentof theexposurewillvarydependingontheamountofdebtborrowedbythefirm.Also,somefirmswill borrowdebtwithmore,orless,fixedorvariableinterestrates.

Each business organisation has a number of choices on how risk exposures may be managed. Forexample,Chapter17discussedtheconceptofinternalandexternalriskmanagementstrategies forthemanagementofforeignexchange(FX)risk.Internalstrategiesincludedinvoicinginthehome currency,creatinganaturalhedge,currencydiversification,leadingandlaggingFXtransactions,markups,counter-tradeandcurrencyoffsets.Externalstrategiesincorporatedtheuseofderivativeproducts.

CHAPTER SNAPSHOT
Financial innovation emerges because companies or institutions find themselves exposed to a risk that they would rather avoid or minimise. Such situations also represent opportunities for financial institutions to engineer new products and profit from doing so, either by charging fees or earning a ‘spread’ between a buy and sell price in a newly created market. Futures, forwards, options and swaps emerged to meet various needs of market participants seeking to manage risk or earn additional reward by bearing risks that others seek to avoid.

A derivative is a financial asset that is primarily designed to manage a specific risk exposure. Aderivativeisbasedonanunderlyingcommodityorfinancialinstrumentthatistradedinthephysical markets.Forexample,acommodityderivativemaybebasedongold,oilorwheat,whileafinancial instrument derivative may be based on shares, share indices, exchange rates or debt interest rates. Withinthecontextofriskmanagement,derivativecontractsenablethemanagementofriskassociated withinterestrates,credit,equity,commoditiesandforeigncurrencies.Derivativecontractsareavailable inthemajorinternationalfinancialmarkets.

Asafinancialasset,aderivativehasaprice.Thepriceofacontractisderived(hencetheterm derivative)fromthepriceofthecommodityorfinancialinstrumentinthephysicalmarket.Theinterest rateriskcontractsderivetheirvaluefrominterestratesecurities,suchasdiscountsecuritiesandbonds thatareissuedinthemoneymarketsandcapitalmarkets.Theequitycontractsderivetheirvaluefrom sharesinlistedcorporationsoronstock-marketindices.Thepriceofacommodityderivativeisbased onaphysicalcommoditysuchasgold,wheat,frozenorangejuice,soybeans,oilorelectricity,toname afew.Currencyderivativesderivetheirvaluefromtheunderlyingforeigncurrency,suchastheUSD, EUR,GBPorJPY,orfromabasketofnominatedcurrencies.

Therearefourbasictypesofderivativeproducts:futures,forwards,optionsandswaps.Thebasic riskmanagementfunctionofaderivativeproductisthatthederivativelocksinapricetodaythatwill applyataspecifiedfuturedate.Forexample,itispossibletoenterintoaderivativecontractthatlocks inaninterestrate,asharepriceoranexchangerate.Bylockinginapricetoday,anidentifiedrisk exposureissaidtobehedged.

 

Thissoundsquiteeasy,butidentifying,measuringanddeterminingappropriateriskmanagement strategieswithinalargeandoftendiverseorganisationisnotsosimple.Asachallenge,youmightliketo spendafewminuteswritingdownalistoftheriskexposurestowhichyouthinkaglobalminingcompany suchasBHPBillitonmightbeexposed.Inthenextsectionweintroducesomeoftheseriskexposures.

REFLECTION POINTS

  • Risk is an integral part of any business organisation.
  • All risk exposures must be identified, measured and managed.
  • The board of directors should establish risk management objectives and policies; management should implement relevant procedures and strategies.
  • Risk management strategies may be internal or external strategies.
  • External risk management strategies incorporate the use of derivative products: futures, forwards, options and swaps.
  • A derivative is a financial asset that derives its price from an underlying physical market commodity or financial instrument.
  • A derivative risk management strategy locks in a price that will apply at a future specified date, such as an interest rate, exchange rate or share price.

18.1        Understanding risk

Thebasicdefinitionofriskisthepossibilityorprobabilitythatsomethingmayoccurthatisdifferent fromwhatwasexpected.Forexample,interestratesandexchangerateschangefromtimetotime. Inearlierchapterswediscussedfactorsthataffectinterestratesandexchangerates.Ariskmanager isabletoconsiderthesefactorsandtrytoforecastwhetherinterestratesmightchangeovercertain planningperiods.Theplanningperiodscouldbeoverthenextmonth,threemonthsandsixmonths. Willinterestratesrise,fallorremainunchanged?Iftheychange,howmuchwilltheychange?How frequentlymighttheychange?Whatimpactwillforecastinterestratechangeshaveonthefinancial performanceofthebusiness?

Theabovequestionsclearlyintroduceuncertaintyintotheforecastingprocess.Forexample,a businessmaybeconfidentthatthecentralbankwillincreaseinterestratesoverthenextsix-month planningperiod.However,itwillbefarlesscertainwhenthismayhappenduringthesix-monthperiod. Willthecentralbankincreaseratesby25basispoints,ormore?Willtherebemorethanonechange? Willlenderspassonthefullmonetarypolicychangetoborrowers?Whatotherfactorsmayaffectthe costofborrowing?

Theaboveinterestrateexampleiscategorisedasafinancialrisk.Wethereforebeginbycategorising riskas:

operationalrisks financialrisks.

18.1.1

OPERATIONAL RISKS

Operational risks are those exposures that may impact on the normal commercial functions of a business,thatis,anypotentialeventthatmayaffecttheday-to-dayabilityofabusinesstodeliverits

LEARNING

OBJECTIVE

18.1

Understand the nature and importance of risk and risk management, and explain the operational and financial risk exposures that a business must manage.

productsorservices.Therangeandscopeofoperationalriskswillvarysignificantlydependingonthe natureofabusiness.

Forexample,acommercialbank,suchasWestpacBankingCorporation,iscriticallyreliantupon itselectronicproductdeliveryandinformationsystems.Amajorfailureofitssystemswillcauselarge lossestothebankandmayresultinthecollapseofthebusiness.

Alternatively,aminingcorporationsuchasBHPBillitonisreliantonthecontinuedoperationof itssmelters.Ifthecompanywasrequiredtocloseanumberofitssmeltersforanextendedperiod,itis likelythatthesharepricewoulddropsignificantlyandmayleavethecompanyexposedtotakeoverby acompetitor.

Asmallercompanymaybeexposedtotheriskoflossofkeypersonnel.Ifanindividualorteam ofpeopleisinvolvedintheresearchanddevelopmentofanewproductforthecompany,thecompany mayhavedifficultycompletingtheprojectifthekeypersonnelleave.Thefuturesuccessofthecompany maybedependentuponbringingthenewproducttothemarket.

Itshouldbeevidentthatoperationalrisksaremanyandvaried.Toassistinourunderstandingof thisformofrisk,wecanidentifysomeofthemainsourcesofoperationalrisksas:

  • Technology—forexample,theloss,failureorredundancyofelectronicproductdeliverysystemsand informationsystems.
  • Property and equipment—for example, the loss of access to the organisation’s buildings due to legionnaire’sdisease,orseveredamagetoanoildrillingplatformfromahurricane,orthedestruction ofanaturalgaspipelinebyterrorists.
  • Personnel—forexample,thedeathofagroupofexecutivemanagersinaplanecrash,oremployees goingonstrikeandforcingbusinessoperationstoclosedownforanextendedperiod.Also,therisk offraudcarriedoutbyanemployeeisanoperationalrisk.
  • Competitors—for example, a competitor developing a new product that outperforms existing productsofferedbyyourcompany,oranothercompetitorwinningcontractsputouttotenderby yourtraditionalclients.
  • Natural disasters—forexample,floods,fire,snowstormsandhurricanesmayallcausedamagesuch thatanorganisationisunabletomaintainnormalday-to-daybusinessoperations.Naturaldisasters canoftenbecatastrophicinthattheymayresultinlossoflifeforpersonnelaswellassignificant damagetophysicalassets.
  • Government policy—forexample,anation-statemayintroducelegislationthatrequiresallcarbonemitting corporations to develop and install new technologies and equipment to lower overall carbonemissionsoftheorganisation.

Suppliers and outsourcing—forexample,thebankruptcyofthemainsupplierofcomponentpartsfor amajorproductproducedbyyourcompany.Also,asupplierisexposedtoalloftheaboverisks;for example,anequipmentfailuremayresultinthesupplierbeingunabletodeliverunderacontract.If acomponentofalargerbusinessprojectorfunctionisoutsourcedtoanotherbusiness,thecompany outsourcing the function is also exposed to the operational