Topic 1 Introduction to Risk 1.1 The Emergence of Risk Management.

The traditional definition of risk was “will the investor get their money back”. In finance we regard risk as “The possibility that an outcome may differ from expectations”. In the finance literature risk is more specifically defined as “variability of returns”. The meaning and implications of this will become apparent as we progress through this course. The risk question is now more likely to be “will this asset generate the required return?” We use statistical measures of risk to assess past performance of an instrument and to help us infer its future returns, and anticipate the variability of those returns. The world financial markets are bigger, and trading in more countries than ever before. Since the emergence of deregulation in major financial markets around the world and the collapse of many price-fixing mechanisms, the open market operations of financial markets participants have seen rapid growth. Trading opportunities for market participants have increased. The increase in trading has increased the variation in prices for financial assets. Increased price variability brings increased risk, and prudent market participants now demand new forms of protection from “unexpected” changes in prices, hence the emergence of new derivatives on a daily basis. The past twenty-five years have seen more changes in capital markets than in the past several centuries. Increased global trade is only one contributing factor to the increase in capital markets activity worldwide. Product diversity in financial markets has grown exponentially. New derivative products, which parse and price specific financial exposures, are brought to market daily. Deregulation in many markets has increased competition, narrowed spreads, and lowered barriers to the flow of capital. As the trend towards deregulation and free markets continues worldwide, market participants are faced with an expanding universe of risks, and the need to meaningfully identify, measure and manage risk. The "secret" of risk management is to know: The risks you are exposed to; If they are big enough to worry about; If there is anything you can do to protect yourself; What it will cost to reduce or hedge your risk?

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Then, if action is needed, do something about it! Ask yourself the following questions:  Are the risks to your business clearly understood – particularly if you have a portfolio of different activities    Do you measure and prioritise risks in a structured way? Do you know the maximum potential liability of each exposure? Are the risks large in relation to the turnover of your business? What impacts may they have on your profit and loss statement, balance sheet, and cash flows?      Are the risks one-offs or are they recurring? Do you know enough about the wthe of at the start in which your risks can be hedged? Is there an effective risk management policy with responsibility at board or senior executive level? Do you clearly differentiate between hedging your risks and speculating for profit? Is Risk Management policy regularly reviewed in light of changes in your risk profile and/or changes in market conditions?    Are there adequate risk monitoring processes? Are colleagues and staff “risk-conscious”? Are decisions being made using timely and accurate information? How quickly can you react to a risk event? That    Is there adequate segregation of duties and responsibilities? Are rewards of your business consistent with the risks? Are the stakeholders happy with the level of risk? Would they prefer reduced return for lower risk? What is their appetite for risk?  What motivates your staff? Are they remunerated in a way that encourages imprudent risk taking, or are risk management policies reflected in remuneration schemes?   Do you have Disaster Recovery Plans in place for a range of consistencies? Do you learn from your mistakes?

1.2 Overview of Risk New classifications and sub-categories of risk are emerging all the time, new tools and techniques for managing risk and new regulatory frameworks are being developed to deal with them. While the main focus of this course is financial risk management, it is appropriate to present the major, broad classes of business risk in overview, so that students gain some broader perspective of the modern field of risk. Principal Business Risks:       Competitors Country Criminal/Fraud Economic Environmental Financial: Counterparty risk (Important aspects of counterparty risk and credit risk assessments are covered in BAFI 1065 – Money Markets & Fixed Income Securities)        Funding risk Market risk; including interest rate risk, foreign exchange risk, commodity price risk, basis risk, and many, many others Information risk Legal risk

Operational risk Personal risk Political risk Product/industry risk Public relations risk Technological risk War/terrorism risk

To some extent the classification of risks shown above is arbitrary and subject to interpretation, but all are relevant to problems faced by businesses around the world, every day. 1.3 Competitor Risk: The realities of competition are well known and understood by anyone in business, but with increasing globalisation, deregulation, and ever-shifting strategic alliances, one should consider the following questions: Do I know where my competition is coming from? (for example, changes in retail financial services in many countries now sees retailers offering financial services, and banks and insurance companies forced to either compete with them or form alliances with them.) Who will I be competing with tomorrow?

1.4 Country Risk: Country risk (also called "Sovereign Risk”) is an amalgam of many factors, but is essentially the risk inherent in dealing with counterparties in a particular country, or with the government of that country. Specific risks that fall under the heading of Country risk include: Political Risk - including exchange controls and restrictions on capital movements, which effect repatriation of profits, remittance of payments, repayment of capital etc.         Social and economic stability Costs associated with visiting the country and employing local/expatriate staff Finding a trustworthy local agent or representative Trading practices, customs and ethics Local commercial law and the effectiveness of its application Restrictions on foreign ownership and management Delays in money transmission Basic problems associated with controlling anything at a distance

Firms should give serious consideration to their tolerance for exposure to these risks - just as firms set limits on their exposures to every other business risk, firms should set limits on how much exposure they are prepared to tolerate to a given country and its risk. Limits should be monitored in view of local political events and reviewed regularly. 1.5 Criminal Risk: Includes Theft, Criminal Damage, Hacking, and Arson  Fraud, which may include, among other things, fraudulent dealing, embezzlement, concealment, "shrinkage " of stock through staff pilfering, When an employee resigns, is dismissed or retrenched, what do they take with them to help in their next job? It is much easier since the advent of the PC for employees to take valuable commercial information with them when they leave a job. Information theft is much easier when a great deal of information can be stored on a disk that fits discreetly in a pocket. Does your firm have password protection at different levels? The more notice an employee has of their departure the greater the time available for such activities, especially if the employee leaves on less-than-good terms. If an employee knows or suspects that they may be asked to leave, they might:    Destroy records, Plant a virus in your computer system, Intentionally enter into contractual or trading commitments on terms harmful to their employer

Industrial espionage is a major problem in some sectors, whether through corrupt employees or sophisticated electronic 'snooping' devices. Businesses susceptible to this risk are usually well aware of the dangers and take appropriate action. It can affect anyone involved in negotiating a major contract or other business transaction. Obvious advice is to shred confidential papers, only discuss business on a "need to know" basis and don't talk loudly to colleagues in public. In some parts of the world, taxi drivers can earn good money by passing on what they overhear on the way from the airport or while taking business people around town. Similarly, sit in any first-class section of a plane or train, and there is a good chance you will hear conversations that should have been confidential. In some territories corruption, cronyism and criminal control of business are endemic. If you must operate in such countries take advice from those who know the area, and be prepared to get on the next plane home if things turn unpleasant, Do you have an agreed procedures insurance cover or contingency arrangements if a member of your staff is taken hostage? 1.6 Economic Risk: Economies are inherently cyclical, with potentially wide fluctuations in activity levels and asset values. However long expected, the transition from a bull to a bear market usually catches people out and leaves them to count their losses. Although governments are generally getting better at managing economies, economic cycles are at least partly driven by a powerful combination of upside greed and downside fear, such that to some extent they will always be with us. Accordingly, the onus is on every business to arrange its financial, counterparty and other activities so as to achieve a reasonable degree of protection from economic boom and bust cycles. Economic risk also includes changes in the competitive position of the country/countries where you are operating; including changes in currency exchange rates, interest rates and relative inflation will affect your profitability. Unless arising from some dramatic event, these changes are likely to be gradual. Even if identified, there may be little that can be done to protect your business in the short run unless you are able to easily re-locate or outsource in another country. 1.7 Environmental Risk: This occurs in many ways, including: The need to comply with environmental or safety legislation, the costs of which can be considerable - it may not even be economically viable to continue your operations higher costs or shortages' of raw materials if your supplier's) are hit by these problems damage to the public image of your business if targeted as environmentally unsound by pressure groups - however seemingly unfair Costs and disruptions that can result from the need to clean up historic pollution - this can be of a magnitude to severely damage or even destroy your business, though the cause may lie long in the past or have been inherited on acquiring a property or business

Litigation by plaintiffs claiming redress for damage to property or health, particularly if you are considered a 'deep pocket' (i.e: of sufficient financial or insured strength to be worth suing). Banks are especially wary of situations such as if they realize a charge on a property or other asset as security, they might be deemed liable for any pollution - indeed, many mortgagees insist on a site inspection or ‘environmental audit' before either taking a charge or taking possession of assets where this risk exists, and some facility agreements require the borrower to warrant that they will not carry out activities on the site that might cause pollution. Diminution in the value of an asset when pollution is found. An asset such as a parcel of land on or under which pollution is discovered will see its market value fall by at least the value of any expected cleanup costs. 1.8 Financial Risk: For our purposes, financial risk falls into four main categories, each of which is considered in more detail in later sections of the course:     Interest Rate Risk Foreign Exchange Risk Funding Risk Counterparty Risk

1.9 Information Risk: The conduct of your business will only be as good as the information on which decisions are based, including:         Costs - at every stage of processes Liabilities - actual and contingent Risks - exposures, maximum potential liabilities and available protection Markets - volumes, efficiency and prices Competitive environment - who your competitors are, their positioning and intentions - present and future Resources - costs and availability, including human resources Technology - using what you have and knowing what you need Financial - cash flows, costs, profits and losses, assets and liabilities (both actual and contingent)

1.10 Legal risk: 1.10.1 Documentation risk Documentation risk results from errors or omissions in documents. These can arise from misunderstanding or ignorance as to the meaning or significance of terms any expressions, or not taking the time and trouble to check a document thoroughly before signing. If subsequently something goes wrong such mistakes can prove very costly. Most everyday contracts are reasonably simple or take a standard form, but how long is it since you read yours through to remind yourself of the detailed terms and conditions? For example: are you happy with procedures to be followed in the event of a dispute?

If the document is out of the ordinary - especially if it involves overseas jurisdictions or counterparties, then be prepared to engage a lawyer - their fee might be the best investment you ever made. But remember that responsibility for negotiating the terms of any deal is yours. Who in your business is authorized to sign documents or otherwise enter into commitments? Are all staff aware of the risks to which they may be exposing the business by seemingly innocent statements or acts? If something goes wrong with a transactions read the background documents before taking action. It is easy to forget their detailed terms and conditions' and you can make matters worse by doing or saying something contrary to an agreement or earlier statement. 1.10.2 Jurisdiction risk Which country's laws regulate any individual contract and the arbitration of disputes? Could a plaintiff take action against you in an overseas court where their prospects of success or of higher damages were greater? Even though the laws of one country govern a contract it may be that the parties could take legal action against each other in a different country. Do you fully understand the implications, including the costs and time commitment that might be incurred if 1t became necessary to resort to the courts? 1.10.3 Security risk If you take security in support of a lending or other transaction make sure:  it can be enforced against the appropriate party(s) in the relevant jurisdictions(s) without incurring disproportionate costs or liabilities  where it is necessary for the security to be “registered”, that this is done within the time period allowed for that purpose  the security documents themselves are put in a safe place with copies available for ease of reference.

1.10.4 Litigation The cost of litigation, in terms of both money and time can be so great that even the most frivolous claim may seriously damage your business. Is arbitration an option? When studying the statutory report and accounts or other communications of a business, look to see if any reference is made to current, pending or past legal actions. Ensure variations to contracts, and any problems outside your control, are recorded in writing with counterparties and consider the legal and other implications before accepting responsibility for anything. Where insurance is available to cover the business and/or its officers and employees this should always be considered. The problem is that premiums are often at a level where many firms cannot afford them or might take out inadequate cover.

There is a widespread belief that, whatever goes wrong, someone else must pay. This 'compensation culture', whatever its justification or causes, is becoming a major problem for many businesses.

1.10.5 ‘Discovery’ It is not widely appreciated that under many legal jurisdictions the 'other side' in a legal action can have the right to see your internal files and records - a process known as 'discovery'. Ironically, the more disciplined the way you run your business, with notes of meetings and decisions, the greater the possibility that you may provide ammunition to your opponents. Those memoranda in which every fact, consideration and contingency are carefully recorded are grist to a lawyer’s mill. There are legally sound, commonsense ways to protect your interests and some documents can be ‘privileged', and thereby not available for inspection provided you act correctly at the appropriate time. If discovery might potentially become a problem it is worth taking legal advice at an early stage. 1.11 Market Risk: In its simplest form this is the exposure to an adverse change in the price or value of something in which you trade or are holding as an investment. An important discipline, where market risk is a factor is the practice of 'marking to market’ on a regular basis. This involves using current market prices to revalue current positions and calculate any profit or loss that has arisen from price movements. Most financial institutions will mark all their open positions to market at least daily. Traders and dealers should admit their mistakes' enabling unsatisfactory positions to be closed out where appropriate, rather than 'running' them in the hope that the market will turn in their favour. The danger is that unless discovered a 'rogue' dealer on a losing streak will need to keep increasing the volume or speculative nature of their trades if they are to have any chance of wiping out an ever-mounting deficit (after all, it is not “their” money!)  Inventory risk: is a variant of market risk - an example of mighty exposure to a fall in the value of securities held by a bank or other financial institution for trading purposes.  Liquidity risk: arises when a market does not have the capacity to handle the volume of whatever you are trying to buy or sell at the time you want to deal.  Hedging risk occurs when you fail to achieve a satisfactory hedge, either because it could not be arranged in the market or as the result of an error. You may also be exposed to basis risk, where the available hedging instrument closely matches but does not exactly mirror or track the risk being hedged. 1.12 Operational Risk: Operational risk includes:  Information and other systems failures, including viruses

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Breaches of security or confidentiality Human error Fraud and theft Weaknesses in internal controls and supervision Physical disasters involving people, premises or equipment Failures of plant and equipment Product liability claims' Logistics/delivery failures Health and safety compliance Staff resource deficiencies, including succession Dependency on 3rd party contractors & outsourcing

The culture of your organisation will be a critical factor in its exposure to operational risk, for which responsibility rests at the top. If you are thinking of changing your IT or other systems, ask the following questions:        Is there really anything wrong with your present system? What are the certain benefits of any change? Will you lose anything which is currently available? Are the gains worth the cost and disruption? Is it better to wait for the next generation? What are the minimum requirements of any new system? These must be guaranteed deliverables. Are there any added bells and whistles likely to be of real value or simply increase the cost and problems whilst delaying installation?   Can you modify or add to the system at a later date? Do you have to disband your present system before the new one has been tried and tested, or can they initially be run in tandem? From the outset, have you involved everyone likely to be concerned with the new system? They comments may be invaluable, and could focus on aspects overlooked by others. You might need their help if things go wrong, which is anyway less likely if everyone is working together. Is the system you are buying tried and tested? What has been the experience of other users? Many otherwise successful businesses have been brought to their knees by the late delivery of failure of new systems. Whatever your systems have you considered the disaster scenario? If, for example, your premises were destroyed by fire tonight, how would you function tomorrow? In many businesses, such as financial trading houses, even a few hours out of action could result in massive disruption and potential losses. For businesses reliant upon computers, there is no excuse for failing to back-up and safely store data. Depending on the time-critical nature of your business, you might also need to maintain backup hardware, or to contract with the company offering disaster support.

What if your records are paper-based, and how you protecting original contracts and key correspondence? After a fire, would you know who owed your money and how much? Essential documents and records can be stored at the bank or in a fireproof safe, with copies kept at another location. Even if not admissible accord, duplicate would be invaluable point of reference. Executives should keep at home a copy of the business's disaster procedures manual and the names and phone numbers of key customers and suppliers, so that they can be contacted in an emergency. This whole area is one where the time to act as before the problem occurs. Decide upon the steps needed to ensure the survival of your business, including insurance cover, and then do something about it -- now!

1.13 Personal risk: Whilst this course is principally concerned with business, the risks of personal liability must not be overlooked. This will largely depend upon:    The legal form of the business, Relevant legislation; and Commercial practice.

In principle, and subject to applicable law, ordinary shareholders are not liable for the debts of a company that has been incorporated with limited liability. Nor are directors liable (unless they have acted negligently or are guilty of wrongfully trading when a business is insolvent) liable for the debts of a company. That said, courts appear increasingly to seek out the “Directing Mind” behind the corporate shield - whether an individual or parent company - and hold them responsible for the acts and deficiencies of the company. This may be particularly relevant where a holding company has overseas subsidiaries as the courts in those countries might be more inclined to pierce the veil of incorporation. A recent introduction in some jurisdictions is the concept of ‘shadow directors' - being those other than the directors of a company who in the event of wrongful trading may be held liable for third party losses (and possibly disqualified from acting as directors) on the grounds that they are deemed to have influenced or controlled the actions of that business. Given the nature of the roles they are sometimes called upon to perform it is important for bankers, liquidators and administrators in insolvency practice to exercise particular care in this respect. For companies with unlimited or restricted liability it is necessary to check the applicable law as to the personal liability of shareholders. Sole traders are normally personally liable for all debts of a business. Partnerships spread the risks amongst the individuals concerned, but usually on a “joint and several basis”. This means that every partner is personally liable for the entire partnership debt. A creditor may choose to pursue just one partner known or believed to be able to pay, leaving it to them to recover any proportion of the monies from their other partners. Before joining any partnership,

ask yourself if you want to be personally liable for all partnership debt that may be incurred by your fellow partners, and if the partnership is solvent? The legal form of any enterprise is of especial concern to those with whom it does business. For example, the knowledge that a sole trader is personally liable can be of greater comfort to a creditor than being owed money by a limited liability company - as bankruptcy remains a daunting prospect for most people who will usually do whatever they can to avoid it. Banks lending to small and medium-sized companies often ask for the guarantees of the controlling shareholders/directors - to ensure their personal commitment and to get behind the protective shield of corporate limited liability so as to be able to pursue individuals for the debt.

1.14 Political risk Never underestimate the potential impact on a business of decisions taken by national and supra-national governments, government agencies and the numerous regulatory bodies empowered to control trade or set prices and industry standards. Their extensive armoury includes the following: Taxation The level and targeting of taxes is infinitely variable, and potentially changeable at short notice; while legislation may be drafted so that it is only in retrospect, and perhaps after testing in the courts, that the basis of assessment can be reliably determined. Uncertainty over taxes, allowances and dividend control can be a serious problem for businesses trying to plan for the future, and may be sufficient to see the cancellation or postponement of otherwise potentially viable projects. Multinationals are particularly careful to take local taxes into consideration and are frequently accused of using transfer pricing to move profits intra-group so as to reduce overall taxes. Quotas, tariffs and other trade barriers Any exporter fighting to win an order in the face of these obstacles knows the problems they can present. Such barriers take many forms including prohibitions on the export of materials or technology that might be of help to another power. It may be possible to legally circumvent these difficulties by entering into local partnerships' but check the position carefully to avoid any risk of criminal charges. Employment Legislation on employment terms, remuneration and conditions of work, however well intentioned, can impact on the ability of a business to trade profitably or to compete internationally. This sometimes encourages previously home-based businesses to relocate part or all of their activities or sourcing to other countries, with potentially harmful consequences for their own domestic economies. Currency exchange controls/inconvertibility These can:  Make it difficult or even impossible for businesses to buy from overseas, if they cannot easily exchange their local currency into the foreign currency needed to pay for imports;

Inhibit or prevented business from operating in, or selling too, another country which operates exchange controls, when sale proceeds of profits cannot be repatriated/remitted.

Interest rates Governments rely in large measure on using interest rates to manage their economies and to control the level of inflation. The problems come with the length of time before effects may be experienced and the impact on the international strength of the country's currency. Grants and subsidies Many businesses are unaware of help available from regional, national governments, and supra- national bodies. This can be considerable, and well worth a time spent making enquiries. Government officials are usually only too happy to help and advice, and exercise care with middlemen, particularly if they ask for an upfront fee. There are many highly reputable consultancy can genuinely assist in obtaining grants and other assistance, but think twice before you risk parting with your money, unless they are known or come highly recommended. Licences/monopolies It is often within the gift of a government to greater rights to develop or exploit a natural resource or business opportunity. Unless selected for the award of a contract or some other participation, or if the government decides to exercise the monopoly itself, you may be totally excluded from that activity. If you when the concession, remember that a government can subsequently changed the rules. Make too much money and you invite withdrawal of licences, expropriation or additional taxes. Environmental/health and safety Legislation controlling industrial zoning, manufacturing processes, emissions, pollution, recycling and health and safety at work can be of considerable impact. Many projects that had looked perfectly viable have come to grief over the costs of complying with subsequently introduced legislation. Even something as apparently straightforward as providing fire exits to meet new safety standards in business premises can be prohibitively expensive. There is not only the capital cost of fire escapes, alarms, sprinkler systems etc, but it may be necessary to change the usage of space in a way that reduces income-earning capacity. Often the likelihood of new legislation is predictable even if its timing may be uncertain, and you can help to protect against the consequences by planning long-term. If faced with unexpected costs, ask if grants or other assistance are available. Nationalisation/expropriation Although the trend worldwide over recent years has been to privatise previously state-run industries, do not overlook the risk of nationalisation or expropriation -- particularly if you are involved overseas in locally sensitive industries or the exploitation of natural resources. The temptation to take over foreign-owned businesses can sometimes proved irresistible to governments and powerful local politicians. It may only take passing of laws restricting foreign ownership to leave you with little choice but to accept whatever local office may be forthcoming for your interests. Restitution In some countries, the former owners of assets have been historically expropriated by the State are entitled to ask for its return all for compensation. If, whether directly or indirectly, you're thinking of investing in assets that might be subject to such claims, check the position thoroughly before parting with your money. 1.15 Product/industry risk

Many of the risks associated with products and services are considered elsewhere in this section, for example under environmental risk, operational risk, public relations risk, resources risk and technological risk. What if your product simply goes out of fashion, or demand declines for other reasons? Often the change can take place gradually, or on a conventional product life cycle pattern, giving time to downsize or switch into other areas. We may have known from the outset that interest would be short lived, as with the use targeted product which they all must have until the next fashion comes along. Occasionally the unexpected happens, and the bottom falls out of your world overnight. The European industry for beef in its derivatives has provided a classic example. The sector was already undergoing change, with some customers moving away from red meat on health or moral grounds, and many small butcher shops closing as supermarkets increasingly dominated the market. Then fears over mad cow disease being transmitted to humans hit the headlines and in many countries the market for beef crashed. It was not just the farmers who were hit, but also their suppliers, meat wholesalers and retailers, and the manufacturers of many other products. Consider another example: in October 1995 the UK's committee on safety of medicines right to doctors and pharmacists with a warning that certain brands of contraceptive pill were associated with a high risk of a type of thrombosis. It was estimated that result in fatalities might occur in one out of every two to 3 million users, which was double the risk for other types of pill. The high-risk pills were not withdrawn from sale, and users were advised to finish the current course. However, many stocktaking and immediately and those who as a result became pregnant potentially doubled their risk of thrombosis. The frequency of such scares, however legitimate, is disturbing as you cannot know which products or industry sectors will be hit next. There is often little any individual business can do to protect against such problems, but it is a different matter for banks and other lenders. To contain the risks, they must mark limits for their exposure to each industry sector. Customers may be upset that otherwise valid borrowing request is turned down solely because it would take the total facilities provided by a bank to that sector above the sector limit, but for the bank to do otherwise would be highly negligent. 1.16 Public relations risk The power of media, environmental and other pressure groups is now a very real issue for many businesses. It is important to be seen to be acting correctly, and easy to innocently fall victim to criticism. You may, for example, have for many years been importing raw material from overseas in good faith. Then you open your newspaper to read an article on the alleged exploitation of the local people or damage done to the environment that region -- with reference to your business by name. It may be necessary to show compassion and to evidence genuine sincerity whilst not admitting liability with its potential legal and insurance ramifications. The time to think about your response to such problems before they happen, including perhaps the appointment of a public relations adviser. Do you have a policy on who is to speak for the business, of which all staff are aware? It can be very damaging for unauthorised employees to feel they must talk to the media -- who are skills at obtaining and editing quotable comments. Can senior employees be contacted in an emergency?

Reputation risk is now taken very seriously, particularly by financial institutions and other industry sectors subject to criticism from their regulators. 1.17 Resources risk Every business uses resources -- from the sole trader providing the time and energy to the multinational leading raw materials, water, power, labour, plant and machinery or transportation. The key issues are: is what you need available?         when required? In sufficient quantity? Of the right quality? At an acceptable price? Will it continue to be available? What are the threats to supply? Is the price likely to change? Are there suitable alternatives?

If your critical resource is an intellectual asset, have you taken the necessary steps to protect it? It may be possible to enter into term contracts for the supply of goods and services, but what if your counterparty defaults, or is prevented from honouring its obligations? 1.18 Technological risk Whilst the person who builds a better mousetrap can take out a patent this is that will help if a way is found of eliminating all mice. Technological risk is the threat the new ways of doing things will reduce or destroy the demand for your existing products, however well established. Just 20 years ago, offices were filled with typewriters -- how many do you have in your business today? 1. 19 War/terrorism Whether you are a buyer or a seller, the risks and opportunities occasioned by war or other hostile acts are selfapparent. Are you too dependent on sales or purchases involving territories of high risk, and do you know where suppliers are obtaining their resources? The widespread use of terrorism in different forms can, by its very nature, present particular problems for business. Was there may be a risk to lie for property, the target is often disruption of normal commercial activity. A few strategically placed on well reported bombs, even if they do not explode, can have a significant effect. If terrorists take foreign tourists hostage, they guarantee media coverage, with potential damage to the tourism industry on which individual businesses or even the local economy may be dependent. A couple of questions to ask:   Do you have disaster recovery plans covering a wide range of terrorist contingencies? Should your executives have kidnap insurance or personal protection?

Careful consideration of country and counterparty exposure with respect to these issues, coupled with insurance cover and appropriate trade finance protection where available, can do much to help reduce these risks.

1.20 Approaches to Managing Risk 1.20.1 Passive Risk Management: Passive risk management takes two forms. The first and simplest is the “do nothing” approach, that is, ignore all exposures. This approach may be acceptable if the exposures of the business are relatively small, in which case the cost of managing the exposures is likely to outweigh any benefit. This approach is often adopted, however, when the company is unaware of the exposures it has. One could argue that this approach is not risk management at all. The second form of passive management is the “cover everything” approach. All exposures that can be identified and sufficiently quantified are fully covered with appropriate positions in appropriate financial instruments. While this approach may be prudent, if executed successfully, a cover everything approach adds significantly to cost, and effectively locks the company out of enjoying favourable market movements.

--------------------------------------1.20.2 Active Risk Management: Active risk management takes the view that risk management strategies should add profit to a business. In its simplest form, active risk management involves leaving part or all of an exposure unhedged when market prices or rates are expected to move in the company’s favour, and taking more “cover” when rates move unfavourably. The success of this approach therefore relies on accurate forecasting of future movements in market prices. A firm’s choice between active and passive risk management approaches will depend on its (and its shareholders’) attitude to risk. This will in turn depend on management philosophy with regard to risk, and the firm’s capacity to bear risk. A firm with wide profit margins and stable sales will be better able to bear risk than a firm with narrow profit margins and volatile sales. 1.21 The Role of Treasury in Risk Management 1.21.1 History: The treasury function is one that has become clearly defined only over the past two decades. Prior to the 1970s, the areas now covered by the treasury function were mostly located within the financial accounting function. With the deregulation of financial markets, particularly the lifting of exchange controls, the nature of the treasurer’s role has become increasingly specialised, and its importance has increased to the extent that treasury has become a well defined functional area in its own right. 1.21.2 What does Treasury do? The treasury function of a private, public or government operation normally involves the following main areas of responsibility: • • fundraising or procurement; liquidity management, including working capital management;

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risk management, encapsulating currency, commodity and interest rate risks; dealing and controls. procurement of funds; management of funds; management of risk.

The main responsibilities of the treasurer cover three main areas:


Treasurers generally operate in one or more of the following Markets: • • • • • Money Market: Bank Bills, Promissory Notes, CDs, treasury notes, repurchase agreements. Bond Market: Commonwealth government bonds, semi-government bonds, Financial Institutions bonds, Corporate bonds, Floating Rate Notes, Asset backed bonds, Non-resident bonds. Interest Rate derivatives: FRAs, interest rate futures, fixed interest futures, swaps, interest rate options, fixed interest options, Caps/collars. Equity Derivatives: Futures, Options. Foreign Exchange Markets: Spot, forward, swaps, options, futures.

1.21.3 Treasury Defined: One leading finance writer defines Treasury as: “the division of a company with responsibility for fundraising, foreign currency management, accounting and taxation. The function of the treasury division and the corporate treasurer vary considerably from company to company” Professor Bruno Thiry says that “In most large corporations, someone is responsible for ordering the stationery… like the stationery department, it (treasury) should service the requirements of those involved in the core activities of the firm”. In the wake of the many famous and infamous corporate and bank treasury cases of recent years, this view is gaining credence, particularly in the corporate sector. There are similarities and distinctions between the role of treasury in a bank and the role of treasury in a corporation. This discussion draws extensively on the readings in your readings pack, and focuses initially on the role of treasury from the perspective of a corporation. As already discussed, most firms will encounter five basic financial risks, each relating to some external variable, usually one or a combination of: • • • • • commodity prices; exchange rates; interest rates; counterparty reliability; and liquidity.

A firm must finance each and every one of its business decisions, and each and every financial transaction will in turn involve at least one of these variables. In most medium to large (and even some small) corporations, it falls to the treasurer to manage the company’s financial risk. The treasurer and the treasury department bear the responsibility for: • • • • • • • Raising funds in the money markets to support the company’s investment and operational activities; Investing the company’s funds in appropriate markets, Buying and selling foreign exchange instruments to manage the company’s foreign exchange risk; Trading in derivatives to manage interest rate, foreign exchange and other risks; Processing transactions and settlements; Treasury accounting; Statutory and internal reporting and compliance;

Advising on and executing board treasury policy.

--------------------------------------1.21.4. The components of a competent treasury: People: Must be trained and professionally competent in treasury matters • • • • • Treasury staff dealers, traders, economists, analysts, managers; Settlement staff settlements, payments, policy, procedures, dealer limits, deal limits and counterparty limits; Accounting staff reporting, accounting standards, disclosure, exposures, policy; Managers understand exposures, instruments, reporting, objectives, benchmarks; Directors understand treasury exposures, set policy, understand reporting, risks and instruments used, set and monitor treasury policy and objectives. In general all personnel in, or associated with, a company’s treasury operations should be willing and able to attend to a wide range of current and future risks. Treasury personnel need a good knowledge of the risk areas their company faces, including: • • • • • • • Foreign exchange; Cash management; Long term liquidity management; Commodity risks; Cash flow forecasting; Bank relationships, and knowledge of bank products and specialties; Treasury accounting issues and requirements.

Further, treasury personnel need to: • • • • • • • • have a broad knowledge of their company’s business and operations; be adaptable and able to select an appropriate response to exposures; have a commitment to “getting things right”; have high ethical standards; commit to accuracy; commit to continuous improvement; adopt and uphold treasury policy; ensure systems are accurate, workable and effective;

Treasury Policy: Treasury policy and procedures are vital components of the control and risk management environment in a firm. Treasury policy and procedures should be fully documented, in plain language, and: • • • Identify and define the company’s treasury objectives; Define levels and scope of authority for treasury staff; Identify and define financial exposures/risks, which will usually encompass: - Foreign Exchange risk; - Interest rate risk; - Credit risk; - Commodity risk (agricultural, mineral, energy); - Liquidity risk; - Operational risk (in treasury) - Transaction risk - Translation risk • • • • • • Define which instruments may be used, and how they may be used; Ensure board of directors understands the nature and risks associated with each approved instrument; Identify and define any instruments with a special risk nature; Define how the company will handle its risks; Identify and define appropriate counterparties in the markets; Define company policy on Trading versus Hedging, stating explicitly: - Whether trading is allowed; - How; - How often; - Trading Limits; - Which instruments can be traded; - Which counterparties; In general, trading should only be conducted with the full knowledge and consent of Board and Management. In most corporations, especially in the current climate, trading is only carried out under exceptional circumstances, and is not usually a daily event. Policy should clearly define segregation of duties, with respect to: • • • Front Office (Dealers and Traders); Back Office (Settlements staff); Accounting staff;

Ideally, none of these functions should be performed or managed by one person or group! Policy should also identify and define: • Statutory reporting, disclosure or other requirements and how these are to be met by treasury and the wider corporation;

Risk Management guidelines, including: - How much exposure to any one instrument or class of instrument - How much risk is attached to each instrument; - Counterparties and counterparty limits (Assessed counterparty exposure); - Mechanisms to report on and handle breaches of limits;

Policy sets the boundaries for the actions and behaviours in treasury. Policy is broad by necessity - it must cover all (known) circumstances that may be encountered. Without exception, policy should be set in consultation with the Board of Directors, senior management, and external advisors such as auditors. Treasury policy should be approved at board level, and revised at least annually. To a large extent, policy will guide the development of Treasury systems and procedures. Systems The third critical element in a competent treasury is the systems in place for management and control. Systems need to incorporate: • • • • A computer system or a good paper system; Treasury policy; Accounting, Settlement and Reporting functions; Transactions should be documented immediately they are executed - On paper and in computer system; - Should include purpose of transaction if not immediately obvious; • Functions should be separated - Deal entry; - Deal confirmation (all deals should be confirmed with counterparties); - Settlement; - Accounting. • • • • • • In addition, systems should ensure that: Appropriate legal documentation is in place for each transaction (especially for OTC deals); System access is appropriately controlled (by password, and by function, so that dealers do not have access to settlements functions etc.); Regular audits are conducted; Positions are marked to market, and mark to market results are reported to management; Sensitivity analysis is conducted regularly, so that treasury, management and the board are aware of and understand risks from market movements (potential losses and gains). --------------------------------------Some other controls issues worthy of consideration: Don’t use instruments you don’t understand - if you don’t understand an instrument and what it does, how can you manage risk with it?

Make sure Board and senior management fully understand the instruments treasury uses and the risks involved: - Especially if there is leverage involved; - Potential losses and profits must be reported, including a worst case scenario and a bail-out position;

Always report to management and Board: - Overall position; - Any surprises (actual or anticipated); - Potential for loss; - Potential for profit; - Current position; - Current risks; - Current costs to cover any uncovered position - Recommended strategy.

1.21.5 The role of Treasury in Risk Management: Among the key decisions facing a treasurer are those of: • • • Determining exposure; Inferring future events; and Mapping an appropriate course of action.

The information required to effect these decisions include: • • • • • • Investment portfolio composition and size; Trading limits; Consolidated trading positions; Economic and market analyses; Evaluation of current conditions; Results of regular evaluation of strategy and performance.

That said, there is little value in a risk-management context in taking sweeping high-stakes initiatives without proper planning. Planning Risk management needs to take in: • • • Policies to properly define risk elements according to specific treasury operations (as discussed previously); Fail-safe limits and damage control measures in case of adverse events; A vision about how to bring deviations from the plan into line, and where to end risk taking.

The bottom line for most treasury operations is hedging, whether full, partial, or perfect. To hedge successfully, the treasurer must be able to determine and evaluate the prospects for profit and loss in prospective positions. High technology is instrumental in the process of gathering intelligence for evaluation of risk, especially where global operations are involved.

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