Essentials of Financial Risk Management

Rick Nason, Brendan Chard

• Publisher: Business Expert Press
• Year: 2018
• ISBN:
  9781947098398
• Topic: Business
• Subtopic: Finance
• Index: Business

Financial risk management is a growing field of specialization in business. With the increased level of regulation and emphasis on financial reporting, the role of the financial risk manager has never been more prominent. This book covers the concepts, tools, and techniques of financial risk management in a comprehensive, yet easy-to-understand manner. Avoiding academic jargon wherever possible, the book has as its objective to be a rigorous, yet practical guide to financial risk management. This book is intended for senior managers, directors, risk managers, students of risk management, and all others who need to be concerned about financial risk management or who are interested in learning more about this growing career path.

CHAPTER 1

The Importance of Financial Risk Management

What Is Financial Risk Management?

Financial risk management is managing the financial variables that affect the firm. It is an ongoing and continual process of identifying financial risks, assessing their potential for harm or opportunity, making a decision of the best managing technique, implementing the chosen risk management strategy, assessing the effectiveness of the strategy, creating a communication network and an associated level of transparency about the risks, and developing impactful risk management reports.

Financial risk management incorporates a set of tools, metrics, and best practices that have been developed over time. Although financial risk management is well developed as a practice, it remains in practice as much of an art as it is a science due to the nature of risk itself.

Financial risk management is a key component of successfully managing a company that has financial exposures, which includes almost any profit-oriented company. Financial risk management is not just a “nice to have” activity, but instead should be considered a necessity. In fact, it is increasingly becoming an expectation of all publicly traded companies. Additionally, it is imperative for senior managers and directors of these companies to familiarize themselves with the tools, techniques, and tactics of financial risk management. Knowledge of financial risk management and an understanding of the role it plays in the competitive success of a company are imperative for good corporate management and governance.

It is important to note that risk is two-sided; it can be either positive or negative. The definition of risk that we use is that “risk is the possibility that bad or good things may happen.” This of course is slightly different from the lay definition of risk. However, financial variables can move in favor of the organization; a key supply commodity can fall in price, interest rates can fall and decrease interest costs and increase demand for a firm’s products, or currency rates may change so as to make a company’s products more price competitive in other countries.

There are three elements to our working definition of risk: (1) risk is about the future, (2) risk has an element of uncertainty, and (3) risk has an upside and a downside to it. Thus, financial risk management is a forward-looking activity that one needs to be aware of and must be flexible enough to deal with uncertainty, and financial risk management needs to manage both good risk and bad risk. It is the last element that often gets neglected in risk management. All too frequently, risk management is focusing on managing the downside risk, while not seeing, and thus not taking or capturing, sometimes even more significant upside risks. Effective financial risk management applies to managing both bad risk and good risk.

Why Is Financial Risk Management Important?

In the last two decades, a wide variety of advanced-level university programs in financial risk management, risk engineering, or risk mathematics have been developed. Additionally, various organizations and certification programs devoted to the field have become popular among practitioners and those wishing to enter this dynamic profession. Most corporations, particularly those with international scope, have organized a dedicated financial risk management department, often including a C-level executive. Of course, this has always been the case for financial institutions, whose reason for being is to manage financial risk, but the prominence of financial risk has also become of almost equal importance in nonfinancial corporations.

There are a wide variety of reasons as to why financial risk management has become so prominent. One of the primary reasons is the globalization of the economy. The rapidity of the rise of globalization has not only increased the level of competitiveness, but also dramatically increased the connectedness of economies. Globalization means that it is no longer sufficient to be the best managed company within your specific home piece of geography, selling products and services to a dedicated and loyal client base. Today’s customer is global, and so is today’s competition. As such, global economic factors and financial markets have the potential to tip the playing scale to one’s advantage or disadvantage. Labor rates, exchange rates, different tax regimes, and differing access to and cost of raw supplies can gain one a competitive advantage or put one at a significant competitive disadvantage. Without the ability to manage these factors, an organization is leaving itself at the whims of the economic Gods and, more importantly, in the crosshairs of their competition who do gain the ability to manage these financial risks.

Also related to globalization is the connectedness of markets. What were once isolated risks, confined to either one specific sector of the market, or one part of the global economy are now events that tend to become globally systemic. This, of course, was most clearly seen during the 2008 financial crisis when basically all major markets globally suffered massive losses in unison. In a global environment, where potentially no one is safe, the need for risk management is key for long-term survival and competitive advantage.

The connectedness of the markets leads to the concept of emergence, which is a fundamental property of what is known as complex adaptive systems. Emergence is a phenomenon that is observed not only in a wide variety of biological systems, but also in economic systems. Emergence explains how fads and feedback loops get started, as well as stopped. Many economists use emergence as an explanation for stock market bubbles and crashes, for the volatility of commodity prices, and for changes in consumer demand for goods and services. A fundamental property of complex adaptive systems is that we can observe trends and patterns after the fact, but are hopeless in our ability to predict them. We will have more to say about complex adaptive systems later in this chapter, but for the moment it is important that the increasing complexity of the global economy increases both the need for and the value of proactive financial risk management.

Awareness of risk management techniques has developed its own kind of feedback loop leading to increased adoption. The rise of financial products for trading financial risks starting in the late 1970s with the emerging markets for future and option contracts led to the development of bespoke over-the-counter products for virtually every financial risk imaginable in the 1990s. That development has continued to the present-day scenario where financial engineering as well as the emerging “fintech” technologies have made the ability to manage financial risk ever more sophisticated, yet ever more accessible to even the leanest of companies. With this increased accessibility to financial risk management products and techniques has come an increased expectation that companies will make use of financial risk management know-how.

Stakeholders expect companies to have a view on financial risk management and to implement that view with the appropriate financial risk management tactics and products—even if that view is that financial risk should not be managed by the company, but by the stakeholders themselves. Stakeholders in an organization are increasingly demanding that the firm develop and communicate a clear risk management philosophy and for them to consistently implement risk management tactics that are consistent with that philosophy. This is a point that we will discuss at length in Chapter 10 when we discuss risk management governance.

Increasingly, corporate stakeholders do not like to be surprised by corporate results that are affected by financial risks that could have been hedged away; with the possible exception of a few select type of companies that explicitly and consciously desire to have their corporate valuation subject to the whims of the financial markets or commodity prices. Share price volatility causes lower share valuations and higher debt financing costs (ironically, a result that is a function of advances in quantifying and managing credit risk). Credit agencies in particular have developed financial models that illustrate how credit ratings, and the associated probability of default, are based on financial share price volatility. Banks routinely make the financial risk management practices of corporations a major part of the credit analysis process, and frequently incorporate specific financial risk management practices as one of the covenants before granting a loan.

Regulators are another group of stakeholders who closely monitor the financial risk management practices of a company. Many industries voluntarily and preemptively implement best practices of financial risk management to avoid having more rigorous risk management imposed on them by regulators. Regulators frequently rely on financial risk management metrics as a way of assessing the viability and the compliance of the firm. This has led to compliance being an integral part of the financial risk management agenda.

Customers and suppliers do not like surprises caused by a lack of appropriate financial risk management practices. Fluctuating prices and shortages of supply can destroy whatever goodwill that a company develops with its customers. Conversely, creatively using financial risk management techniques can provide a competitive advantage in both attracting new customers and keeping existing customers.

Case Study

Irving Oil

Irving Oil is an integrated energy company headquartered in Saint John, New Brunswick, which through its subsidiary Irving Energy, provides customers, both industrial and retail consumers, a “Price Cap program” which it describes as follows:

With Irving Energy, you can cap your home heating rate for 12 months! With Cap Pricing, you pay a small fee to ensure that your price will never go higher than the capped price. But should prices go down, you get the benefit of paying the lower price.

This is analogous to buying a call option: you pay a premium and are protected if market prices rise, but retain the benefits if prices fall! This type of contract provides access to hedging options for many companies without the sophistication or desire to trade financial products on their own. The customer now knows that regardless of how high market prices go over the next year, they will never have to pay more than the agreed-to price cap. This increases their budgeting and forecasting abilities, increasing the probability of meeting financial objectives. The 12-month term offered by Irving is quite standard, and does not provide any protection from rising market prices beyond the following year.

An often neglected stakeholder group that might be one of the most impacted by inappropriate financial risk management is the employees, and by extension the future employees, of the organization. There is the obvious impact of the company going bankrupt. Other major concerns exist though beyond the existence of the company and its related job security. Many employees have share ownership programs. Excessive levels of stock price volatility impact them directly in the value of their personal portfolios. Perhaps, the biggest impact is value volatility of pension programs. As the baby boomers begin to retire, underfunded, or excessive volatility in pension plans will become more exposed and make companies more vulnerable in the war to attract talent.

An industry of training for risk management expertise has developed to supply managers the expected expertise. What was once considered to be esoteric and solely for the specialist is now common place. For instance, back in the early 1990s, swaps were considered a novel and hard-to-understand product. They were new, novel, and cutting edge. Now swaps are covered in virtually every undergraduate business program as part of the core curriculum, and are considered as mundane a product of risk management as a calculator might be. During the 2008 financial crisis, products such as credit derivatives and highly structured collateralized debt obligations, more commonly known as CDOs, were likewise considered esoteric, but it is likely that their use will someday be seen as common. Today, we have fintech products such as blockchain and cryptocurrencies that are new and novel. These tools are already changing the financial risk management landscape in profound ways and new developments will continue to emerge.

It is not just knowledge of the risk management products themselves that is important. It is also an increasing awareness of the tools, tactics, and measures of risk management. Everyone, from Board members to the newly hired employee, is expected to be familiar with a range of financial risk management topics. Awareness has created an expectation. It has also created a demand for risk management educational opportunities, as well as professional certifications. Two of the major risk certification programs are the Professional Risk Manager designation, offered by the Professional Risk Manager’s International Association (PRMIA), and the Financial Risk Manager designation granted by the Global Association of Risk Professionals. To meet the demand, Universities are creating specialized degree programs in financial risk management and financial engineering.

Ultimately, the major stakeholders in financial risk management are the managers themselves. Higher volatility of stock prices, particularly when caused by hedgable risks, is seen as a sign of ineffective management, and thus careers and career progression are at stake for managers whose financial risk management skills are not competitive. Even mid-level managers need to be aware of how financial risks can affect the achievement of their operational goals, and failure to understand the risks and to manage them is considered inexcusable and potentially career limiting.

Strategic Importance of Financial Risk Management

A common misperception is that financial risk management is simply about controlling the volatility of costs, prices, and credit risk. Financial risk management ultimately has its biggest virtue in being a major element of implementing the strategic plan. The hedging strategy of the firm has a direct role to play in not only setting, but also implementing a strategic plan for competitive advantage. How an airline chooses to hedge its fuel costs also helps to determine the pricing strategy relative to its competitors. The pricing plans a company offers its customers, based on its own financial risk management, can become a comparative advantage in the eyes of its customers. Mining companies can decide whether their value is based on their effectiveness of mining commodities, or based on the value of the commodities they mine on the basis of their financial risk management strategy.

Thus, for many companies, financial risk management has relatively little to do with the direct financial results and a lot more to do with implementation of the strategic plan. In those companies, financial management is truly value-added and a source of competitive advantage. An effective financial risk management strategy allows for a much wider set of alternatives for the strategic vision of the firm. Financial risk management becomes a catalyst and an enabler for strategic management.

Types of Financial Risk

There are six major types of financial risk, and a few specialty classifications as well. Although there are similarities in how each of these types of financial risk is managed, there are also specific differences between them. There are different measures for risk in each of the markets, as well as specific market dynamics that need to be accounted for in how the financial risk management products work in each of the markets.

Perhaps the most prominent financial risk is interest rate risk. It is the risk that arises through changing interest rates. Interest rate risk affects not only financing costs, but also potentially affects demand for a firm’s products or services. Of course, interest rates also affect the overall economy, which affects all companies. Consider for a moment the effect of interest rates on the demand for housing, automobiles, and other high-ticket consumer items. However, effective financial risk management can mitigate the negative effects of interest rate changes and likewise help the firm leverage advantageous changes in interest rates.

The second most prominent financial risk for managers to be concerned about is currency risk which arises through changes in exchange rates between countries. Currency risk is closely related to interest rate risk as it is directly tied to the relative interest rates between countries. It is a common misperception that currency risk is only an issue for organizations that have international operations or sell their products internationally. However, in the global economy, all companies are affected by currency risk as it changes the relative competitiveness of foreign competitors and foreign substitutes. If the domestic currency strength...

Table of contents

• Cover
• Half Title Page
• Title Page
• Copyright Page
• Contents
• Acknowledgments
• Introduction
• Chapter 1 The Importance of Financial Risk Management
• Chapter 2 Financial Risk Management Tools and Tactics
• Chapter 3 Financial Risk Management Frameworks
• Chapter 4 Financial Risk Management Metrics
• Chapter 5 Interest Rate Risk Management
• Chapter 6 Currency Risk Management
• Chapter 7 Energy Risk Management
• Chapter 8 Credit Risk Management
• Chapter 9 Commodity Risk Management
• Chapter 10 Financial Risk Management Governance
• Chapter 11 The Future of Financial Risk Management
• About the Authors
• Index