CHAPTER 1 The Need for Risk Management All of life is the management of risk, not its elimination. —Walter Wriston, former chairman of Citicorp Corporations are in the business of managing risks. The most adept ones succeed; others fail. Whereas some firms accept risks passively, others at- tempt to create a competitive advantage by judicious exposure to risks. In both cases, however, the risks should be monitored carefully because of their potential for damage. This chapter motivates the need for careful management of finan- cial risks. Section 1.1 describes the types of risks facing corporations and argues that financial risks have increased sharply over the last 30 years. The need to hedge against these risks had led to the exponential growth of derivatives markets, which are described in Section 1.2. Derivatives are very efficient instruments to hedge against, or speculate on, financial risks. Used without proper controls, however, they have the potential for creat- ing large losses. Thus they should be used only with good risk manage- ment. Section 1.3 explains the evolution of risk management tools, which has led to the widespread use of value at risk (VAR) as a summary measure of market risk. Finally, the various types of financial risks are discussed in Section 1.4. 1.1 FINANCIAL RISKS What exactly is risk? Risk can be defined as the volatility of unexpected outcomes, which can represent the value of assets, equity, or earnings. Firms are exposed to various types of risks, which can be classified broadly into 34 PART I Motivation business and financial risks. This classification will be developed further in Chapter 20 on integrated risk management. Business risks are those which the corporation assumes willingly to create a competitive advantage and add to value for shareholders. Business risk includes the business decisions companies make and the business en- vironment in which they operate. Business decisions include investment decisions, product-development choices, marketing strategies, and the choice of the company’s organizational structure. This includes strategic risk, which is broad in nature and reflects decisions made at the level of the company’s board or top executives. The business environment includes competition and broad macroeconomic risks. Judicious exposure to busi- ness risk is a core competency of all business activity. Other risks usually are classified into financial risks, which relate to possible losses owing to financial market activities. For example, losses can occur as a result of interest-rate movements or defaults on financial obligations. For industrial corporations, exposure to financial risks can be optimized carefully so that firms can concentrate on what they do best— manage exposure to business risks. In contrast, the primary function of financial institutions is to man- age financial risks actively. The purpose of financial institutions is to as- sume, intermediate, or advise on financial risks. These institutions realize that they must measure financial risk as precisely as possible in order to control and price them properly. Understanding risk means that financial managers can consciously plan for the consequences of adverse outcomes and, by so doing, be better prepared for the inevitable uncertainty. 1.1.1. Change: The Only Constant The recent growth of the risk management industry can be traced directly to the increased volatility of financial markets since the early 1970s. Consider the following developments: * The fixed exchange rate system broke down in 1971, leading to flexible and volatile exchange rates. * The oil-price shocks starting in 1973 were accompanied by high inflation and wild swings in interest rates. * On Black Monday, October 19, 1987, U.S. stocks collapsed by 23 percent, wiping out $1 trillion in capital.CHAPTER |The Need for Risk Management $s + In the bond debacle of 1994, the Federal Reserve, after having kept interest rates low for three years, started a series of six consecutive interest-rate hikes that erased $1.5 trillion in global capital. * The Japanese stock-price bubble finally deflated at the end of 1989, sending the Nikkei Index from 39,000 to 17,000 three years later. A total of $2.7 trillion in capital was lost, leading to an unprecedented financial crisis in Japan. * The Asian turmoil of 1997 wiped out about three-fourths of the dollar capitalization of equities in Indonesia, Korea, Malaysia, and Thailand. ¢ The Russian default in August 1998 sparked a global financial crisis that culminated in the near failure of a big hedge fund, Long Term Capital Management. * On September 11, 2001, a terrorist attack destroyed the World Trade Center in New York City, freezing financial markets for six days. In addition to the horrendous human cost, the U.S. stock market lost $1.7 trillion in value. The only constant across these events is their unpredictability. Each time, market observers were aghast at the rapidity of the changes, which created substantial financial losses. Financial risk management provides a partial protection against such sources of risk. To illustrate the forces of change in the last 40 years, Figures 1-1 to 1-4 display movements in exchange rates, interest rates, oil prices, and stock prices since 1960. Figure 1-1 displays movements in the U.S. dol- lar against the Deutsche mark (now the euro), the Japanese yen, and the British pound. Over this period, the dollar has lost about two-thirds of its value against the yen and mark; the yen/dollar rate has slid from 361 to close to 100, and the mark/dollar rate has fallen from 4.2 to 1.5. On the other hand, the dollar has appreciated by more than 50 percent against the pound over the same period. In between, the dollar has reached dizzy- ing heights, just to fall to unprecedented lows, in the process creating wild swings in the competitive advantage of nations—and nightmares for un- hedged firms. Figure 1-2 also shows that bond yields have fluctuated widely in the 1980s, reflecting creeping inflationary pressures spreading throughout na- tional economies. These were created in the 1960s by the United States,6 PART I_ Motivation FIGURE Movements in the dollar. Value of dollar (index) British pound Japanese yen ° T T T T T T 1960 1970 1980 1990 2000 trying to finance the Vietnam War, as well as a domestic government- assistance program, and spread to other countries through the rigid mech- anism of fixed-exchange-rates. Eventually, the persistently high U.S. in- flation led to the breakdown of the fixed exchange rate system and a sharp fall in the value of the dollar. In October 1979, the Federal Reserve force- fully attempted to squash inflation. Interest rates shot up immediately, be- came more volatile, and led to a sustained appreciation of the dollar. Bond yields increased from 4 percent in the early 1960s to 15 percent at the height of the monetarist squeeze on the money supply, thereby creating havoc in savings and loans that had made long-term loans, primarily for housing, using short-term funding. Figure 1-3 shows that oil prices also have fluctuated widely. The sharp oil price increases of the 1970s seem correlated with increases in bond yields. These oil shocks also had an impact on national stock mar- kets, which are displayed in Figure 1-4. Indeed, the great bear market of 1974-1975 was a global occurrence triggered by a threefold increase in the price of crude oil. This episode shows that it is difficult (o understandCHAPTER 1 The Need for Risk Management 1 FIGURE 1-2 Movements in U.S, interest rates. 10-year yield (%) o T T T T T T T 1960 1970 1980 1990 2000 financial risk without a good grasp of the underlying economics, as well as the links between major risk categories. In addition to this unleashed volatility, firms generally have become more sensitive to movements in financial variables. Prior to the 1970s, banks were either heavily regulated or comfortably cartelized in most in- dustrial countries. Regulations such as ceilings on interest-rate deposits effectively insulated bankers from movements in interest rates. Industrial corporations, mainly selling in domestic markets, were not too concerned about exchange rates. The call to reality came with deregulation and globalization. The 1970s witnessed a worldwide movement to market-oriented policies and deregulation of financial markets. Deregulation forced financial institu- tions to be more competitive and to become acutely aware of the need to address financial risk. Barriers to international trade and investment also were lowered. This globalization forced firms to recognize the truly global nature of competition. In the process, firms have become exposed to a greater variety of financial risks,