Concise guide to

treasury risk management

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As with any publication of this nature, the information contained in this publication is of a general
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The Institute of Chartered Accountants in Australia 2010
First published August 2010
Published by: The Institute of Chartered Accountants in Australia
Address: 33 Erskine Street, Sydney, New South Wales, 2000
Concise guide to treasury risk management
First edition
ISBN 978-1-921245-61-9
3
Foreword

Risk management continues to be an evolving and valued practice. The events of
recent years with the effects of the global fnancial crisis have clearly shown the
importance of well developed risk management strategies and processes.
It is in this regard that the Institute of Chartered Accountants in Australia (the
Institute) has developed this thought leadership initiative entitled, Concise guide
to treasury risk management. This guide is aimed at the senior management
and audit committee level and will assist these groups recognise and ask the
appropriate questions when they are addressing fnancial risk instruments within
their own organisation.
This guide is the second in a series designed to assist Directors and Audit
Committees meet their responsibilities. This plain English guide, assists in
the understanding of an organisations treasury functions and is directed to
non-fnancial institutions.
Experience has shown that treasury functions fulfl an important part of an
organisations operations. However, at times it can be an area due to its nature
and complexity, that does not receive suffcient governance attention. The
Institute believes this guide will facilitate the communication and governance
of the Treasury functions.
I trust that you will fnd this guide useful and practical in your organisations
unique risk management needs.
Michael Spinks FCA
President
Institute of Chartered Accountants in Australia
The Institute of Chartered Accountants in Australia
Concise guide to treasury risk management
5
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Identifying risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
The role of the Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Market risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Operational risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Contents
The Institute of Chartered Accountants in Australia
Concise guide to treasury risk management
Overview
This guide is designed to assist members of audit committees of non-fnancial
institutions to fulfl their governance roles. It addresses some of the key issues
surrounding the major fnancial risks facing an organisation, as well as the use of
fnancial risk instruments.
This guide will discuss risk management issues associated with the treasury and
fnancial instruments used by an organisation to manage interest rate and foreign
exchange risk.
While this guide does not directly address commodity and energy risks for
audit committees, the risk issues are the same as for foreign exchange or
interest rates.
Risk or compliance?
Risk management is not compliance; compliance is what you do to meet
regulatory or statutory legislation. Risk management is what you do for the
beneft of your organisation. Risk management should add value to your
organisation at all levels; otherwise it is not maximising its value.
Most organisations, including not-for-proft and smaller fnancial institutions,
consider themselves in a low fnancial risk environment because they do not
speculate. While this may lead to smaller volumes of fnancial instruments
compared to large trading organisations, the fnancial risks of these instruments
are the same. One of the biggest areas of fnancial risk applies to the purchasing
and selling of fnancial instruments, including derivatives, whether they are used
to trade or hedge a position.
Every audit committee must understand the importance of a suitable risk
management framework for their organisation.
Financial risks are a necessary part of every organisations fnancial operation,
large or small, public or private. These risks include:
Market >
Credit >
Liquidity >
Operational. >
7
This guide examines these risks. Depending on the risk appetite of the
organisation, it may wish to increase them, eliminate or even share them
with a fnancial institution.
Financial instruments can be used to reduce or hedge some market risk and to a
lesser extent credit and liquidity risks. Be aware, though that the use of fnancial
instruments will in turn create operational risks.
The Institute of Chartered Accountants in Australia
Concise guide to treasury risk management
Identifying risk
Why does an organisation use these products? >
Are they the appropriate products? >
These are two fundamental yet very important questions senior managers and
audit committee members must be able to answer.
Financial instruments have an important role to play within any organisation
so audit committee members should be aware of and understand the need for
their use. For instance, borrowing in USD is considered risky for AUD revenue
companies. However, if they sell their goods in USD a natural hedge is often
created. If this happens it can help to limit the USD currency risk.
In considering when to use fnancial instruments, some important questions
must be asked.
What are the organisations fnancial objectives? >
What impact will the fnancial exposure have on proft? >
What will be the fnancial impact on proft, cash fow and dividend? >
Will these positions need to be hedged or are there offsetting exposures to >
limit/negate the position?
What will hedging actually achieve? >
9
The role of the Board
Good risk management starts with the organisations Board setting appropriate
risk management and treasury policies. The Board must take an active interest
in those treasury activities, as well as the products in which the treasury deals.
Boards are also responsible for deciding on the organisations risk appetite and
for communicating those risk policies to all employees. An organisations risk
policies and appetite can be hard to defne; therefore, the Board often fnds this
a diffcult area to manage.
Questions for the audit committee points to consider
Has the Board established an internally consistent and clear risk management >
policy, including risk limits appropriate to the risk appetite of the organisation?
Have appropriate limits and authorities been approved? >
Have risk management objectives and policies been approved by the Board >
and communicated to all staff?
Are management strategies and implementation policies consistent with the >
Boards authorisation?
Does senior management have a good understanding of the organisations >
fnancial risk activities and treasury operations?
Are senior managers involved in setting policies for treasury and risk >
management goals?
The Institute of Chartered Accountants in Australia
Concise guide to treasury risk management
Market risk is usually defned as the movement in value due to a change in
price, creating a positive or negative value for the organisation. However, most
organisations consider this variability in price to be undesirable and prefer to
lock in a known exchange rate or cost. Organisations can do this by buying
all their foreign goods and services in the domestic currency and letting other
entities handle the risk. Alternatively, an organisation may choose to take no
cover or handle the risk itself through the use of currency instruments. Currency
instruments used include forward foreign exchange (FX), foreign currency
options or combinations of both.
Many organisations make decisions to hedge all known exposures by the use
of forwards. However, while this may provide certainty it does not allow for the
opportunity of taking advantage of favourable moves in the exchange rate.
Although usually perceived as being too expensive, FX options are a better
alternative, especially if bought or quoted during times of high volatility of the
exchange rate. They allow full fexibility of movement in the exchange rate while
protecting the organisation from any exchange rate downside. Consider these
products in the same way as car and house insurance. Purchasing FX options
may be considered as fnancial insurance. The best outcome is when you dont
exercise your option, as this means the exchange rate has moved in your favour.
Some organisations may choose to remain unhedged during a fnancial year.
For instance, several mining companies prefer to remain unhedged in both their
currency and commodity exposures.
When an organisation borrows from off-shore, cross-currency swaps may be
used. Cross currency swaps allow both the foreign currency and the interest rate
to be locked in.
Each organisation must consider its alternatives and attentively compare
its risk appetite with stakeholder expectations. These issues must be fully
communicated especially if any change of policy is proposed and/or it will have a
large impact on potential profts.
Interest rates are considered differently, as they are generally based on more
long-term up and down movement in interest rate trends. Most organisations
borrow money on a foating basis against a bank bill swap reference rate (BBSW)
or a bank benchmark. They look to fx interest rate costs over a three to fve
year term, depending on their view or debt profle. The preferred instruments
for fxing an interest rate are interest rate swaps and interest rate options. Caps
are interest rate options that protect the borrower from increasing interest rates,
while foors protect the investor from falling interest rates.
Market risk
11
Questions for the audit committee points to consider
Are risks identifed as early as possible to ensure adequate steps are taken to >
handle the exposure in a timely manner?
Do risk measurement methodologies measure the risks adequately and in a >
timely manner?
Are potential stress tests and what if analyses undertaken monthly (eg. >
measuring sensitivity of exposure to market risk [VAR] and scenario analysis)?
Is there a suitable mix of foating and fxed interest rates? >
What is the foreign exchange risk hedging policy? >
What percentage of foreign exchange is hedged? >
Is the audit committee informed of any breaches of market risk policy or limits? >
The Institute of Chartered Accountants in Australia
Concise guide to treasury risk management
Credit risk, often called counter party risk within wholesale markets, is the risk
that your counter party defaults before or on settlement date. Organisations
must judge this risk when dealing with fnancial institutions and other corporate
clients. Counter party risk is usually handled by reviewing the credit limits
published by the rating agencies where each fnancial institution is given a credit
limit based on the published rating:
AAA rating $100 million limit >
AA rating $50 million limit >
A rating $20 million limit. >
How these limits are determined is usually based on an analysis of each fnancial
institution and the Boards risk appetite, rather than a detailed credit study of
each organisation.
Trading fnancial instruments through a licensed stock or futures exchange
means counter party risk is almost negligible, because the clearing house
guarantees performance of the contract.
On the other hand, using over-the-counter instruments means you would be
trading with major banks, investment banks and other institutions that have
credit limits with your organisation. Unfortunately, it is very hard to estimate the
credit risk of these organisations to your organisation.
Part of counter party risk is settlement risk, which is the risk that the
counter-party will default on the day of settlement particularly when it comes
to foreign exchange settlements. Also carefully consider if you pay or receive
collateral from a counter party (collateral may be used when you have limited
credit lines with a counter party). If collateral is necessary, ensure you have
appropriate policies in place with regard to the management and recording of
such collateral.
Credit risk also includes country/political/sovereign risk. This risk covers
governments legislative change and is usually beyond the control of either party.
Credit risk
13
Questions for the audit committee points to consider
What processes are in place to determine credit limits? >
Is there adequate capacity to measure credit exposure? >
Does the organisation have a process for handling and valuing collateral >
received or paid?
Does the organisation have settlement limits? >
What reliance is placed on credit ratings provided by a credit rating agency? >
Is credit risk appropriately managed? >
Is the audit committee informed of any breaches of credit or settlement >
limits immediately?
The Institute of Chartered Accountants in Australia
Concise guide to treasury risk management
Liquidity risk covers two important risks. It covers the risk of not being able to
deal in a market due to lack of liquidity, and funding risk, which is not having
adequate funds in place when they are needed. For most organisations usually
the larger of these two is funding risk.
Many organisations manage funding risk by developing detailed cash fows for
a rolling 12-month period. Detailed cash fows are critical for the survival of the
organisation and must be continually updated based on current factors and
realistic assumptions.
Using fnancial instruments can add to further volatility on cash fow, such as
when exercising an option. Locking in an exchange rate using currency forwards
may help reduce this volatility.
To mitigate funding risk a detailed fnancing plan is usually developed, on a
yearly basis at least.
When developing the plan consideration must be given to ensuring diversifed
sources of currency and funders, as this will help in times of a major fnancial
downturn in any single market. All organisations should run various risk
scenarios that consider potential adverse conditions and whether further
emergency funding lines may be needed.
Questions for the audit committee points to consider
What processes are in place to measure liquidity risk? >
What impact do fnancial instruments have on cash fow? >
Are appropriate cash limits in place? >
Are secured funding lines in place? >
What level of security do these funding lines have? >
Is close contact kept with funders, shareholders and bankers? >
Are there diversifed sources of funds? >
Is there a spread of products and maturities so that maturities do not build up? >
Is there liquidity in all the various fnancial instruments eg. any exotic or >
structure products?
What stress scenarios are run and are they stressful enough? >
Is the audit committee informed of liquidity stress issues in a timely manner? >
Liquidity risk
15
Operational risk is the most varied of the major risks. It is usually defned as
loss due to failure of people, processes and systems, or an external event such
as fre, fraud, food, earthquake or other natural phenomenom. For accountants
and fnance professionals, operational risk also includes accounting and
valuation risk, issues that are vitally important for any organisation when fnancial
instruments are used.
Operational risks are managed by having relevant policies, detailed procedures
and most importantly, well-trained and experienced staff.
Questions for the audit committee points to consider
Are all staff who are responsible for monitoring derivative transactions well >
trained and qualifed?
What is the culture of staff and management toward risk and controls? >
Have staff adequate expertise for the roles that they perform? >
Are bonuses paid based on the results of any risk management or >
treasury activities?
Is there an independent system for calculating and reporting to calculate and >
report results?
Are treasury operations handled by internal staff with the appropriate >
treasury skills?
Are front and back offce systems adequate and appropriately segregated >
to ensure the completeness and accuracy of processing, settlement and
verifcation of the value of outstanding transactions?
Are valuation and spreadsheet models independently reviewed? >
Are all back offce staff adequately trained and do they understand the >
products used?
Are the organisations systems capable of producing adequate disclosure >
information for users of the fnancial statements?
Are accounting results routinely calculated and regularly reported? >
Do the external auditors have a clear understanding of their role in verifying >
the fnancial transactions?
Are the policies and procedures reviewed at least annually? >
Operational risk
The Institute of Chartered Accountants in Australia
Concise guide to treasury risk management
The reporting of risks is crucial to the management of risk within any
organisation. It is important to set reporting benchmarks as early as possible to
ensure targets are relevant to outcomes. Reports must be clear, concise, timely
and relevant, and must provide a complete picture of the organisations fnancial
risk in a format that can be used and understood by senior management and
the Board. So that the required decisions can be made, senior management and
the Board must feel secure about the provided information. For instance the use
of graphs rather than absolute numbers is a clearer way of showing reporting
trends. Depending on the needs of the organisation, some risk reports will be
on a daily basis, usually market risks and counter party reports, while others are
more appropriate as weekly, monthly and quarterly reports.
Questions for the audit committee points to consider
What fnancial gains and losses does the organisation want reported on a daily, >
weekly and/or monthly cycle?
Is treasury performance appropriately measured and regularly reported? >
Are the treasury activities reported to senior management in a timely manner >
and in an appropriate format?
Is the organisational and reporting structure appropriate for ensuring that all >
fnancial risks are appropriately managed without internal conficts?
Are fnancial risks clearly highlighted and monitored in Board and audit >
committee reporting?
Are key risk changes clearly highlighted? >
Are future possible risks considered within the reporting format? >
Are reports audited yearly and reviewed by senior fnance staff with >
relevant training?
Who independently monitors and reviews treasury reports? >
Reporting
17
Glossary
BBSW Bank bill swap reference rate, used by the industry
as a benchmark for interest rate swaps and forwards
and foating rate notes.
Cross currency swap Long-term hedging deal that enables an organisation
to lock in both an exchange rate and an interest rate in
a foreign currency, again a great risk management tool.
Foreign exchange
forward
A foreign exchange deal due for settlement greater
than spot and most commonly used by organisations
for hedging their foreign exchange exposure.
Foreign exchange
option
A transaction used to protect a foreign exchange
position without locking in a forward rate, a very
useful hedging product.
Foreign exchange
swap
A transaction where the foreign currency is bought
and sold in the same deal for two different dates,
used to fund foreign currency bank accounts.
Futures Mainly used to manage interest rate risk or equity risk
on licensed futures markets or commodity risk on
global futures markets.
Interest rate option To manage an interest rate risk, a cap protects you
from rising interest rate costs used by borrowers, and
a foor protects you from falling interest rates, used by
investors. Like insurance a premium is paid upfront to
buy protection.
Interest rate swap Used by organisations to swap from a foating interest
rate borrowing to a fxed interest rate borrowing,
usually over a three to fve year time frame.
Spot foreign exchange A foreign exchange transaction due for settlement in
two business days from deal date, the rate that is
most commonly quoted in the media and on screens.
VAR A widely used risk measure of the risk of loss on a
specifc portfolio of fnancial assets.
The Institute of Chartered Accountants in Australia
Concise guide to treasury risk management
Notes
Concise guide to treasury risk management
19
Notes
Concise guide to treasury risk management
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