[IMGCAP(1)]It’s easy for managers to overlook risks. Financial risk managers may ignore nonfinancial risks. Business managers responsible for a particular line item (such as costs) may downplay risks unrelated to their particular line item. Firms often manage their risks compartmentally — for example: the treasury department for foreign exchange and interest rates; the procurement department for commodity purchases; and the insurance department for catastrophic risks.

By its nature, any derivatives transaction introduces an enterprise-wide risk, even if it has a narrow purpose. Therefore, derivative transactions must be analyzed and managed systematically to ensure consistency with corporate objectives, suitability of the transaction, and avoidance of unintended consequences of the process.

Many soft risks can be avoided by following the steps on this derivatives transaction checklist:

•         Verify consistency with risk policy and corporate objectives. Has the risk policy been updated to reflect current business strategy?
•         Consider the impact of potentially offsetting risks on the balance sheet.
•         Examine legal and regulatory requirements to assure compliance.
•         Anticipate possible future legal and regulatory changes.
•         Simulate possible outcomes of the derivative transaction under many scenarios.
•         Establish the correct accounting treatment.
•         Ensure the accounting treatment has the desired result in all scenarios.
•         Understand when the desired accounting treatment cannot be attained.
•         Make sure the firm has the personnel and systems to trade, monitor, and report derivatives activity.
•         Communicate objectives to all stakeholders.
•         Plan communication strategies for alternative future outcomes.
•         Anticipate reputational risk due to possible adverse outcomes.
•         Predetermine performance measurement criteria.
•         Undertake review by audit committee (some firms will have a risk management committee).
•         In the absence of sufficient internal expertise, seek outside evaluation.
•         Determine in advance how ongoing valuations and risk assessments will be performed.
•         Provide updated performance reports referencing communicated objectives.
•         Study exit strategies in the event that conditions change materially.
•         Consider personal political risk to managers under different outcome scenarios.

Failure to Reduce Risk
Although a derivative usually meets its narrow goal of reducing a particular risk, it is often the case that the derivatives transaction fails to reduce corporate risk materially. Indeed, some may actually increase the overall net risk profile.

For example, many firms hedge their foreign exchange risk carefully, perhaps not realizing that foreign exchange risk may be a very small part of the overall corporate risk profile. In many cases, tacit speculation occurs under the guise of hedging, particularly if the trading activity gets hedge accounting treatment.

More generally, derivative transactions supported by a particular department will likely reduce departmental risk but may not reduce the overall risk of the firm. For example, a large software firm may want to hedge its interest rate risk, without realizing that the interest rate risk pales in comparison to the business risks of software development and sales.

The only remedy for this problem is to build a firm-wide risk model, even if it is approximate in many ways, to understand the impact of a particular derivatives strategy on the firm. The firm-wide risk model should include market, credit, operational, and event risks in order to be as complete as possible. With this kind of model in place, the benefits of risk management can be more precisely measured in order to compare the benefits to the costs.

The following steps may be added to the checklist above:

•         Build a model of the firm that simulates all material risks.
•         Overlay the proposed derivative on the firm model.
•         Test cash margin requirements, credit exposures, and accounting outcomes from the model.
•         Document courses of action for select scenarios.

Creation of New Risks with Derivatives
There is a kind of law of conservation of risk in the universe. Risk is neither created nor destroyed, merely transformed into different risks. Hedging market risk creates margin risk if hedging is done on exchanges, and it creates counterparty risk if it is done over-the-counter. Hedging also creates operational risks if the hedger is ill-prepared to manage the unanticipated consequences of hedging. In this section we will describe the three major risks created by derivative transactions.

Market risk. Hedging creates incremental market risk in many different scenarios. For example, most hedgers cannot hedge their risk perfectly—a corn farmer in Vermont may hedge with Illinois corn futures, exposing the farmer to fluctuations in corn value between Vermont and Illinois. Market risk is also created when the hedger overhedges, such as when an oil producer hedges planned production from a well to find out that the well does not end up producing oil. Finally, market risk is created when the underlying risk profile of the company changes and its derivative contract does not. For example, the size of an exposure to counterparty default will generally vary with changes in market prices. If the company hedges counterparty risk but the exposure doubles, it is no longer hedged.

Credit risk. Hedging creates credit risk whenever a specific counterparty is involved. This may be a bank party to an OTC derivatives trade, or it may be an insurance company. A company’s own credit may be impaired by hedging if hedging creates future cash margin requirements that compromise the company.

Operational risk. The large number of soft risks may be inferred from the list above. Here we emphasize that even a firm that hedges may find it does not have the valuation, validation, monitoring, reporting and execution skills to maintain derivative strategies. In some cases, strategies were designed poorly because of the unfamiliarity of the analysts with the risks they were modeling.3 Particularly when a company chooses to reverse a particular strategy, it is prone to losing significant sums due to trading with sophisticated counterparties.

The most important thing for the CFO is to be aware of the dangers in order to manage them. Derivatives comprise a specialized subfield of financial management requiring specialized skills. A CFO with analytic support from people experienced in derivative transactions and risk management stands a better chance of executing derivative strategies successfully than one who does not have this support.

Unfortunately, many CFOs have nowhere to turn but to their counterparties for advice. This is like asking the wolf to guard the sheep. The counterparty has a position of conflict and, even if qualified, should not advise a corporation on derivatives strategy.

Another problem CFOs have is that senior management expect them to have the skills necessary to evaluate and execute derivative transactions, even though this is a highly specialized subfield of financial management. Yet, the best source of advice is an independent adviser who is familiar with the company’s risk policies and profile, and familiar with the markets and instruments under consideration for the hedge.

It is tempting to think that a financial executive need only read a textbook on derivatives to be effective, but this could not be further from the truth. In fact, unscrupulous counterparties can take advantage of executives whose knowledge is textbook-oriented.

Nothing beats practical experience.

The preceding article will appear in “QFINANCE: The Ultimate Resource,” which will be published this fall by Bloomsbury Publishing. Visit www.qfinance.com for more information.

David Shimko holds a PhD in finance from Northwestern University. He has taught finance at the Kellogg Graduate School of Management at Northwestern University, the Marshall School of Business at the University of Southern California, the Harvard Business School, and the Courant Institute at New York University. His professional career included positions at J.P. Morgan, Bankers Trust, and Risk Capital, an independent risk advisory firm that was sold to Towers Perrin in 2006. Currently, Shimko sits on the board of trustees of the Global Association of Risk Professionals. He acts as an independent financial consultant and continues to teach part-time at the Kellogg School.

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