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F UCTURE
MANAGING
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FINANCIAL RISK
by Simon Jegher
n my 10 years managing finance/trea- tions and investment bankers point to the fact
I
sury departments, I have spent consid- that, other than in financial institutions, a uni-
erable effort addressing the financial fied and comprehensive financial risk manage-
imperatives of two of Canada’s largest ment focus is likely an exception.
corporations: cash management, The objective of such a process is, first and
including banking and committed lines foremost, to address the key policies relating to
of credit; external financings, averaging financial risk exposures. For example, credit
$1 billion per year, in the global capital mar- ratings are too often seen as simply the fallout
kets; early calls of publicly held debt; deriva- of financial performance, not the result of poli-
tives; pension funds; debt rating agencies; and cies tailored to attaining a specific rating that
all the other associated functions that are the addresses a firm’s long-term capital require-
bread and butter of our daily corporate finance ments. A credit rating policy can set up other
lives. Yet, I always felt a need for a greater capital structure strategies and an appropriate
structure that would bring together these func- fixed/floating composition of the debt portfolio.
tions and the people who implement them—a Another objective of a unified process is to
flexible structure that would encourage the foster a consolidated perspective of financial
innovation required to create financial benefits risk—not only the risk to the company itself,
and shareholder value. but its subsidiaries and parent, where applica-
While on vacation two years ago on a peace- ble. Similarly, for companies with defined bene-
ful, somewhat remote, island off the west coast fit pension plans, the plan’s assets and liabilities
of Florida, I spent a few evenings churning out must also be incorporated into this consolidated
concepts, financial instruments, risks and func- perspective, recognizing that financial risks
tions as they randomly occurred to me. Before I affecting off-balance-sheet items can have signif-
knew it an entire wall was blanketed with yel- icant impacts on cash flows and net income.
low notes. The next few evenings were spent Finally, a comprehensive process brings to light
rearranging the ideas and concepts into a struc- the dynamics between disciplines, thus focusing
ture. While none of the parts of the process are various operating units on common objectives.
innovative on their own, my subsequent dis- For example, liquidity policy will affect the tim-
cussions with both Canadian and U.S. corpora- ing of capital market transactions just as foreign
-2-
Policy Development
Business Review Budgeting Forecasts: Cost of equity, asset cash flow matching, subsidiaries,
pension fund, business cycle correlation
-3-
Operating
Operating Environment: External financing requirements, tax (current and forecasted rate),
Environment economic and capital markets
Assessment
Rating Agencies: Rating outlook, debt capacity, view of financial instruments
FINANCIAL PROCESS
-4-
Development of Acceptable Risk Tolerances: e.g., budget variances, rating implication,
Risk cash flow variances, trust indenture
Tolerances
Communication
• Executive approval
-5- Development of Policies and Objectives Counterparty Policy
• credit rating • Board approval
Policies • Target credit rating
• institutions
& • Capital structure and dividend policy
• notional limits
Objectives • Duration and fixed-floating mix of debt • swap agreements
Portfolio Software
• evaluation
• implementation
• caps
-6-
• commercial paper • floors
Strategy program • collars • fixed-floating ratio consolidated counter-
& • maturity distribution • forwards • duration party exposure model
Implementation • lines of credit • swaps
• etc.
• securities buyback
• interest rate hedging arbitrage • medium-term
• option monetization note program • swap agreements
• early calls efficiency
analysis
-8-
Performance
Development and Measurement of Benchmark Portfolio and Risks
Measurement
& Evaluation
exchange policy will affect the nature of deriva- management process is the identification of the
tive strategies. various risks.
Liquidity Risk—Even companies with a
Policy Development highly tuned focus on customer and sharehold-
The first step in creating an active financial er value can go bankrupt because they lack
short-term liquidity. Short- and longer-term any exposures that undoubtedly exist in the
cash forecasts, combined with worst-case busi- pension fund’s equity and debt portfolios.
ness and economic scenarios, are vital for the Given the publicity surrounding their occasion-
development of a corporate liquidity policy. In al abuse, the use of derivatives might be seen as
turn, this policy will drive ceiling short-term a hard sell to a board of directors. My experi-
debt levels, the size and term of committed ence has shown that boards are receptive to
bank lines of credit and the timing of fixed, derivative use if there is a clear objective of
long-term financings. restricting their use to managing, controlling
Foreign Exchange Risk—A question: Unless and reducing risk combined with appropriate
your company is a financial institution, why are internal controls and reporting.
you taking any foreign exchange risk at all?
Corporate risks should be taken in areas of the Quantification
company’s core expertise. However, analyzing Having identified the firm’s financial risks, the
your corporation’s FX exposure will raise some next step in the process is to quantify the dollar
interesting questions. What exposures are built risk associated with each of them. This requires
into the supply procurement process? If you a dynamic financial model that incorporates the
have a defined benefit pension fund, what is firm’s consolidated financials, long-term busi-
the potential impact of currency exposures? ness plans and off-balance-sheet items such as
While currency risk is integral to the pension pension fund assets and liabilities, leases,
fund’s investment diversification strategy, an derivatives in place and securitization transac-
FX gain or loss could impact the sponsor cor- tions such as the sale of receivables.
poration’s cash contributions to the pension Quantification will require a risk assessment
fund. These and other questions particular to based on various business and economic sce-
your firm’s operations will raise policy issues narios.
that might otherwise go unaddressed.
Interest Rate Risk—The key policy issue that Assessment
determines a firm’s interest rate risk is capital The next step in the process involves a thor-
structure. Thereafter, the primary measure of a ough assessment of the business and operating
company’s debt portfolio interest risk should be environment. For example, how is the firm’s
duration, which is driven by cash flows, as business correlated to the economic cycle? A
opposed to simply utilizing the average life of high correlation might imply that the firm is
the portfolio. Ideally, the duration of the debt capable of assuming higher interest rate risk,
portfolio should be equal to the duration of the assuming rates increase as the economy heats
firm’s assets—an objective that is difficult to up. Similarly, a firm whose markets are aggres-
apply to most companies unless they are finan- sively under attack and whose base technology
cial institutions. Having established a duration is undergoing rapid change should consider
policy, the key implementation decision is taking relatively lower financial risks. (While
determining a fixed/floating mix of debt that sat- this sounds obvious, too many firms groping to
isfies both liquidity and interest rate policies. At be competitive attempt to reduce financial costs
Bell Canada, we have assessed a number of the- by making short-term capital market bets.)
oretical, custom-designed studies, all of which Another aspect that requires assessment is the
point to an approximate 80 percent to 20 per- firm’s prospective view of its long-term debt
cent mix of fixed/floating debt as being the most credit ratings. This total environmental assess-
effective over the longer term. ment determines the appropriate level of finan-
Counterparty/Credit Exposure—A key cial risk.
advantage to derivatives as a risk management
tool is that they allow for the modulation of Risk Tolerance
duration without necessarily increasing liquidi- The level of risk tolerances that a corporation is
ty risk. The best example is borrowing prepared to accept should encompass the
long/fixed and swapping into floating. aggregate of all the identified financial risks and
Similarly, derivatives can be a cost-effective and is dependent on a number of factors. How
flexible vehicle for implementing a foreign much variance in budgeted earnings and cash
exchange policy. Their use, however, comes at flows is tolerable to management, the board
a price. Derivatives result in counterparty credit and the shareholders/capital markets? What
exposure which itself requires a clear policy will be the reaction of the rating agencies to dif-
and operating controls. This policy should ferent levels of earnings and cash flow volatili-
address credit criteria and specific credit limits ties? How much room for variance exists in the
on a consolidated corporate basis, including company’s debt trust indenture tests?
Implementation
Having developed a set of financial risk policies
approved by the board of directors, the next
step is implementation and assuring that poli-
cies are adhered to. The intellectual foundation
must be one of managing the entire lower right
hand side of the balance sheet as a single port-
folio that finances the corporation’s operations,
with the focus on cash flows generated from
both sides of the balance sheet.
Strategy implementation is the more familiar
of corporate financial operations and calls for a
financial risk management process specifically
addresses two of the five: