Introduction to Foreign Exchange and Risk Management

Mayank Gupta Email: forex.iipm@gmail.com Mobile: +91.9999.433.817

What?
Primary Objectives
Provide knowledge to help you get a great job Provide information for job interview questions Promote you as IIPM students Apply your economics/accounting/finance skills to issues in todays news to help understand: What is information is conveyed through those news How that information affects todays and tomorrow's business decisions that firms take How to be a sophisticated user of this information

What My objectives
My objective is not to make your life miserable My objective is not to overload you with irrelevant assignments or make-work tasks My objective is to make this class relevant, useful, stimulating, fun and enjoyable
You have many commitments But, the lowest cost, lowest effort approach to benefit from and cruise through this class is to attend class Basically, I am serving it to you on silver platter

What is risk?
Is it the risk of a loss? (adverse selection) It is the result of an exposure Also an opportunity for gain Events with a low probability of occurrence but a high potential for loss are troublesome It creates variance of expected returns Is it always possible or desirable to eliminate the risk?

General aspects
To create value, companies need to take risks. But they try to avoid those risks that carry no compensating gains. No two companies are exposed to the same risks. Risk management has to be tailored to each case.

General aspects
Risks put managers under pressure.
They need to decide if it makes sense for companies to hedge or insure their risks.

Main risks:
Business risks = damages of any kind affecting operating income Financial risks Changes in commodity prices Changes in interest rates Changes in exchange rates

Risk management
A process to deal with uncertainties The most important = assess the risks Develop management strategies consistent with internal priorities and policies
Risk tolerance and objectives

It can provide a competitive advantage

The process
Identify, evaluate and prioritize key business and financial risks. Determine an appropriate level of risk tolerance. Implement risk management strategy in accordance with policy. Measure, report, monitor, and refine as needed.

Evidence on risk management

Almost all firms do, to some extent. Most take out insurance policies against fire, accident and theft. They also hedge currency, commodity or interest rate risks. Many firms have contracts that fix prices of raw materials or output, at least for the near future.

Evidence on risk management

It depends on managers personal risk aversion. Hedging is more common when management has large shareholdings in the company. It is less common when top management holds lots of stock options.
Remember that the value of an option falls when the risk of the security is reduced.

The firms that hedge the most have high debt ratios and low dividend payouts.
Hedging seems to improve firms access to debt and to reduce the likelihood of financial distress.

Why manage risk?

Risk reduction does not come for free. Hedging is (in theory) a zero-sum game. The risk is passed to someone else.
In an efficient market, parties negotiate terms that are fair (zero NPV) on both sides of the bargain.

Investors do-it-yourself alternative.

Corporations cannot increase the value of their shares by undertaking transactions that investors can easily do on their own. Shareholders can adjust their exposure.

Why manage risk?

In perfect financial markets, risk management is irrelevant. But risk-reducing transactions make sense in practice:
Reduce risk of cash shortfalls Better financial planning Catch valuable investment opportunity Reduce risk of financial distress Banks and bondholders are aware of the risks and require hedging

Why manage risk?

Agency costs
Better monitoring of managers Better identification of good management No impact of fluctuations that are outside the managers control Hedging ties the bonuses more closely to risks that managers can control

Operating divisions can hedge risks internally to the central treasurers office. The treasurer can cancel out risks or hedge.
Operating managers are not supposed to take speculative positions (a debate?)

Methods of Risk Reduction

Avoidance (drop activities) Mutualization (insurance) The use of financial markets and instruments Diversification Transforming the risk (global management)

Insurance
Most businesses buy insurance against hazards. Taking insurance is transferring the risk to the insurance company. Insurance companies have some advantages in bearing risk.
Experience (estimate the probability of loss) Advice to reduce risk (lower premiums) Risk pooling (diversified portfolio of policies)

But not macroeconomic risk

Insurance
Premiums can be large, insurance can be a costly way to protect against risks
Administrative costs (disputes) Adverse selection

Insurers increase premiums to compensate bad risks

Moral hazard

Once a risk has been insured, the firm is less careful

Insurance companies issue Catastrophe bonds

They dont pay the interest if a catastrophe happens The bondholders co-insure the risk

Financial instruments
Forward contracts Futures exchanges Options Swaps Credit derivatives More sophisticated instruments

Diversification
Diversification is an important tool in managing risks. Diversification among counterparties may reduce the risk that unexpected events adversely impact the organization through defaults. Diversification among investment assets reduces the magnitude of loss if one issuer fails.

Diversification
Diversification of customers, suppliers, and financing sources reduces the possibility that an organization will have its business adversely affected by changes outside managements control. Although the risk of loss still exists, diversification may reduce the opportunity for large adverse outcomes.

Transformation
Systemic approach Global strategy Long term issues

VAR Value At Risk

"You only have to do a very few things right in your life so long as you don't do too many things wrong." - Warren Buffett For investors, risk is about the odds of losing money, and VAR is based on that common-sense fact. By assuming investors care about the odds of a really big loss, VAR answers the question, "What is my worst-case scenario?" or "How much could I lose in a really bad month?"

VAR Value At Risk

Value at Risk (VaR) is defined with respect to a specific portfolio of financial assets, at a specified probability and a specified time horizon. The probability that the mark-to-market loss on the portfolio over the time horizon is greater than VaR, assuming normal markets and no trading, is the specified probability level. Value at Risk (VAR) calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will decline in value by more than $1 million over the next day, assuming markets are normal.

Price volatility
The financial world has become more risky. Inflation is relatively low, but uncertainty about future inflation remains. Interest rate volatility (affect debt and cost of capital) Exchange rate volatility (future exchange rates are very difficult to predict with precision) Commodity price volatility (oil prices are increasingly uncertain)

Change predicting
Indicators that predict changes in economic activity in advance of a slowdown are useful. The yield curve may be one forecasting tool. Changes in consensus forecasts and short-term interest rates, are warnings of a change in the direction of the economy.
Studies have found that a good predictor of changes in the economy one year to 18 months forward has been the shape of the yield curve.

Short-run and long-term exposure

In the long run, a corporation is economically viable or not. Hedging cannot change the fundamental reality. By hedging (short term), a firm gives itself time to adjust to fundamental changes in market conditions.

Hedging (a hot debate)

There are three broad alternatives for managing risk:
1. Do nothing and actively, or passively by default, accept all risks. 2. Hedge a portion of exposures by determining which exposures can and should be hedged. 3. Hedge all exposures possible.

Theory of hedging
Find two closely related assets Buy one and sell the other in proportions that minimize the risk of the net position If assets are perfectly correlated, the net position is risk free If they are less than perfectly correlated, absorb some risk
Look at how the prices of the two assets have moved together in the past

Theory of hedging

Hedges can be static or dynamic

You can sleep, the firm is protected Or you need to rebalance the position to maintain the hedge as prices change

Some companies prefer speculation

It doesnt make sense for an industrial company

Accounting systems and risk management systems

Traditional accounting calculates and analyzes past and current losses
Most of the risks are off-balance-sheet activities There are accounting problems, like when trading with derivatives Result is that a component of the profitability doesnt appear in the reports

Shareholders and financial analysts find it difficult to assess performance, while regulators and rating agencies face problems when they try to determine the riskiness of the activities (your homework).

ERM Enterprise Risk Management

ERM can be described as a risk-based approach to managing an enterprise, integrating concepts of strategic planning, operations management, and internal control. Goals of an ERM program
Organizations manage risks and have a variety of existing specialized departments that identify and manage particular risks. However, each risk function varies in capability and must coordinate with other risk functions. A central goal and challenge of ERM is improving this capability and coordination, while integrating the output to provide a unified picture of risk for stakeholders and improving the organization's ability to manage the risks effectively.

A Case Study
Smith Night Club (see separate document)
Risk assessment was done The manager wrote down who could be harmed by the hazards and how. For each hazard, he wrote down what controls were in place. He then compared these controls to the good practice. The manager wrote down what else needed to be done to control the risk. The manager decided and recorded who was responsible for implementing the actions identified as necessary and when they should be done. At the staff meeting, the office manager discussed the findings of the risk assessment with staff. He decided to review and update the risk assessment every year.

13 questions on risk management

What is the company's philosophy towards financial risks? Do supervisory board members understand the financial instruments the company uses or owns, particularly derivatives? Who formulates the firms guidelines and policies on the use of financial instruments? Has the board approved these policies? How can the board foster a risk management culture within the firm? How does the board ensure the integrity of the risk management system? Is there a separation of duties between those who generate financial risks and those who manage and control these risks? What type of financial instruments may the firm use? How are these financial instruments valued? Is there a limit system in place? What are the major risks resulting from financial instruments? Are senior managers and the board of directors kept aware of the financial exposures facing the company? As a shareholder, how much information on the financial risks of the company can I reasonably expect?