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P1.T1. Foundations of Risk

Chapter 2. How Do Firms Manage Financial Risk?
Bionic Turtle FRM Study Notes
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Chapter 2. How Do Firms Manage Financial Risk?

COMPARE DIFFERENT STRATEGIES A FIRM CAN USE TO MANAGE ITS RISK EXPOSURES AND EXPLAIN
SITUATIONS IN WHICH A FIRM WOULD WANT TO USE EACH STRATEGY. .......................................... 3
EXPLAIN THE RELATIONSHIP BETWEEN RISK APPETITE AND A FIRM’S RISK MANAGEMENT DECISIONS.
............................................................................................................................................... 4
EVALUATE SOME ADVANTAGES AND DISADVANTAGES OF HEDGING RISK AND EXPLAIN CHALLENGES
THAT CAN ARISE WHEN IMPLEMENTING A HEDGING STRATEGY. .................................................... 4
APPLY APPROPRIATE METHODS TO HEDGE OPERATIONAL AND FINANCIAL RISKS, INCLUDING
PRICING, FOREIGN CURRENCY AND INTEREST RATE RISK. ........................................................... 6
ASSESS THE IMPACT OF RISK MANAGEMENT INSTRUMENTS, INCLUDING RISK LIMITS AND
DERIVATIVES. .......................................................................................................................... 6

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Chapter 2. How Do Firms Manage Financial Risk?

 Compare different strategies a firm can use to manage its risk exposures and explain
situations in which a firm would want to use each strategy.

 Explain the relationship between risk appetite and a firm’s risk management
decisions.

 Evaluate some advantages and disadvantages of hedging risk exposures and explain
challenges that can arise when implementing a hedging strategy.

 Apply appropriate methods to hedge operational and financial risks, including

pricing, foreign currency and interest rate risk.

 Assess the impact of risk management instruments, including risk limits and
derivatives.

Compare different strategies a firm can use to manage its risk

exposures and explain situations in which a firm would want to use
each strategy.
The risk manager should first understand the firm’s risk appetite and map its key risks. Then he
or she can handle each risk. This includes two steps:
1. First, define the most important exposures and prioritize these risk exposures; i.e., which
risks are urgent and/or most severe?
2. Second, assess the costs and benefits (aka, ROI) of available risk management tactics.
 Retain: No firm seeks to avoid every and all risks. The firm seeks to accept some
risks in their entirety; for others, the firm may accept some segment of the loss
distribution. Some retained risks may be large. This is a key job of risk management:
to decide which risks to retain.
 Avoid: Firms might avoid so-called unnatural risks. The easiest avoidance tactic is to
stop an activity. If a firm makes the claim of “zero tolerance,” it should ask whether
the statement is sincere: often this claim is rhetorical rather than accurate.
 Mitigate: Collateral is a common risk mitigation. A firm can also mitigate via
operational means; e.g., more efficient or safe production processes
 Transfer: Insurance and derivatives are common means of risk transfer.
Regarding the larger risks, the board and senior management is responsible for the selection of
risk management strategies (and tactics).

Some risks are more difficult to quantify than market risk, especially technology and the “new
insurable risks.” Cyber risk is an ideal example of a risk that requires worst-case analysis and
expert judgement; e.g., a 3% estimated chance of a $90 million data loss event.

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Explain the relationship between risk appetite and a firm’s risk

management decisions.
Appetite is willingness, while capacity is the maximum: Risk appetite is how much (i.e.,
the level or degree), and which types of, risk the firm will accept. Risk capacity, on the
other hand, is the maximum amount of risk the firm can absorb.

Corporations increasingly inform investors of their board-approved risk appetite. The risk
appetite statement should be approved by the board. The trend is to make risk appetite
statements more explicit.

Risk appetite is:

 An articulation of the firm’s willingness to assume risk while it pursues its business
objectives. A detailed risk appetite statement is typically an internal document, but often
an abbreviated version appears in the (disclosed) annual corporate report.
 The mechanisms that link the top-level risk appetite statement to the firm’s day-to-day
operations, including: a detailed risk policy, business-specific risk statements, and the
framework of risk limits.
The risk appetite should be consistent across risk types and consistent with the firm’s expertise:
some firms are conservative while others are entrepreneurial. But such characterizations, if
accurate, depend on the firm’s actual risk practices.

Evaluate some advantages and disadvantages of hedging risk and

explain challenges that can arise when implementing a hedging
strategy.
Disadvantages of hedging risk
 May distract management
 Requires special talent, knowledge and/or skills
 Often requires specific data
 Implies additional compliance costs; i.e., disclosure, accounting
 There is a classic trade-off between economics (aka, cash flow) and accounting: to
reduce cash flow volatility might increase earnings (accounting volatility)!

Advantages of hedging risk

 Financial distress has a significant cost. Of course, bankruptcy also has a cost, but
financial distress does not require bankruptcy. Corporations hedge to reduce their
chance of default. Even when default is not a threat, reduction of financial distress (i.e.,
probability of default) is a significant benefit.
 Hedging non-core risks liberates management to focus on the firm’s organic economic
performance. This focus may allow management to communicate a more effective
message to stakeholders.

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 Hedging can reduce the firm’s cost of capital (this may be the best argument).
Specifically, hedging may reduce the firm’ weighted average cost of capital (WACC).
1. Campello et al. sampled 1,000+ firms (focusing on interest rate and FX
derivatives) and found hedging to reduce the cost of external financing. They
showed hedgers were able to invest more than non-hedgers.1
2. Geczy et al (in an earlier study)2 investigated the use of foreign currency
derivatives by Fortune 500 nonfinancial corporations. They found that ~41% of
firms had used currency derivatives (i.e., swaps, forwards, futures, and/or
options). Their primary conclusion was “that firms with greater growth
opportunities and tighter financial constraints are more likely to use currency
derivatives.” They inferred that the rationale was to reduce cash flow fluctuations
to elevate capital raising.
 Hedging may have tax benefits: Under progressive tax rate schemes, volatile earnings
imply higher total taxes. Further, hedging might increase the debt capacity of a
company.
 Hedging natural risks tends to be synergistic with the firm’s operations. For example, by
hedging a commodity’s price (as a production input) a firm can stabilize its costs and
implied price scheme for customers. Price stabilization may offer a competitive
advantage in the marketplace3

There are challenges while implementing a hedging strategy:

 The firm might misunderstand the risk to which it is exposed; or similarly, the firm may
fail to notice changes in the environment (or market structure) that alter these risks
 The temptation to use risk management tools, especially derivatives, to achieve goals
that do not genuinely reduce risk. For example, an interest rate swap might temporarily
reduce interest rate costs, but it also adds downside risk (if rates move adversely).
Derivatives, by definition, are leveraged and therefore can enhance both return and risk;
therefore, if they are used to boost returns, it might be easy to disguise such use as risk
management.

1 M. Campello, C. Lin, Y. Ma, and H. Zou, “The Real and Financial Implications of Corporate Hedging,”

Journal of Finance66(5), October 2011, pp. 1615–1647

2 C. Geczy, B. A. Minton, and C. Schrand, “Why Firms Use Currency Derivatives,” Journal of

Finance82(4), 1997, pp. 1323–1354

3 Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New

York: McGraw-Hill, 2014)

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Apply appropriate methods to hedge operational and financial risks,

including pricing, foreign currency and interest rate risk.
Mapping the Risks
After setting objectives and deciding on the risks to be managed, the firm must map
relevant risks. Using foreign exchange as an example:
 If the board has decided to hedge currency risks, the firm’s chief financial officer (CFO)
will map the specific FX risks likely to arise from exchange rate fluctuations
1. The firm will record assets and liabilities that are sensitive to exchange rate
changes
2. Date will be collected on orders from foreign clients (for each currency) that are
due over the next year
3. All expected expenses over the coming year that are denominated in foreign
currencies should be traced.
 This mapping exercise can be applied to other risky positions and their risk factors
 The firm should sort the “Top 10“ greatest risk exposures to the firm
1. For each “Top 10” risk, quantify the probability of occurrence and severity (either can
be specified by a distribution) in some time-frame such as the next year
2. Since 1998, the SEC (in the U.S.) has required publicly traded companies to quantify
their exposure to financial instruments linked to changes in interest rates, exchange
rates, commodity prices, and equity prices. However, the SEC does not require firms
to assess their underlying or “natural” exposure to changes in the same risk factors.
When mapping risks, we should distinguish between: risks that can be insured, risks that can be
hedged, and risks that are non-insurable and non-hedgeable. This matters so that the
appropriate hedge instruments can be identified.

Assess the impact of risk management instruments, including risk

limits and derivatives.
The next step (after mapping risks) is to identify instruments, some of which can be devised
internally, that can manage exposures.
 For example, a U.S. firm with British pound-denominated assets can also borrow money
in pounds (and match the maturities) and achieve a natural hedge.9
 One internal division might have a euro-denominated liability while another holds euro-
denominated assets. Such internal (aka, “natural”) hedges avoid transaction costs and
some of the operational risks associated with explicit derivatives.

9Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New
York: McGraw-Hill, 2014)

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Exchange-traded versus over-the-counter (OTC) instruments

Over-the-counter (OTC) instruments are private contracts between two parties. Exchange-
traded instruments trade on public venues. The essential difference is that exchange-traded
products are more liquid, while OTC products can be customized.
 Exchange-traded instruments are standardized and therefore can only cover a limited
number of underlying assets. Contract specifications (e.g., option strike prices, option
maturities) are defined and set in advance by the exchanges in order to commoditize
the product and promote liquid market.10
 Over-the-counter (OTC) products are issued by investment or commercial banks. Their
chief advantage is that they can be tailored to customers’ needs.
1. For example, an OTC option on the British pound can be customized by size,
maturity, and strike price. OTC instruments can be made to “fit” a customer’s risk
exposure quite closely, but they tend to lack the price transparency and liquidity
advantages of exchange products.
2. A key concern in the OTC market is counterparty credit risk. During the financial
crisis of 2007–2009, many OTC contracts collapsed or endured an extended period
of uncertainty about the ability of counterparties to honor them; but all exchange-
based products were honored.11

There are range of instruments available for hedging risk and these can be categorized
into swaps, futures, forwards, and options. Various instruments with their defining
features are provided below:

10 Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New

York: McGraw-Hill, 2014)

11 Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New

York: McGraw-Hill, 2014)

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Figure 2.6: The risk management toolbox12

Instrument Type Defining Features

Forward It is a tailored agreement to exchange an agreed upon quantity of an
asset at a pre agreed price at some future settlement date. The asset
may be delivered physically, or the contract may stipulate a cash
settlement (i.e., the difference between the agreed upon price and some
specified spot or current price).
Future It is an exchange-listed forward with standardized terms, subject to
margining
Swap It is an over-the-counter (OTC) agreement to swap the cash flows (or
value) associated with two different economic positions until (or at) the
maturity of the contract. For example, one side to an interest rate swap
might agree to pay a fixed interest rate on an agreed upon notional
amount for an agreed upon period, while the other agrees to pay the
variable rate. Swaps take different forms depending on the underlying
market.
Call Option The purchaser of a call option has the right, but not the obligation, to buy
the underlying asset at an agreed upon strike price, either at the maturity
date (European option) or at any point during an agreed upon period
(American option).
Put Option The purchaser of a put option has the right, but not the obligation, to sell
the underlying asset at the agreed upon strike price at the maturity date
(European option) or at any point during an agreed upon period
(American option).
Exotic Option There are many different options beyond the standard or plain vanilla
puts and calls. These include Asian (or average price) options and basket
options (based on a basket of prices).
Swaption It is the right, but not the obligation, to enter a swap at some future date
at pre-agreed terms.

Dynamic hedging strategies are sophisticated but also require expertise. The traditional
risk management technique is the use of limits, which are simple but easy to understand
and often very effective. Many consider limits to be the best tactic due to their simplicity.
The next table illustrates various types of limits.

12 GARP (Global Association of Risk Professionals, 2020)

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Figure 2.5: Limits—Example Types13
Limit Nature
Stop Loss Limits Loss threshold and associated
action (e.g., close out,
escalation)
Notional Limits Notional size of exposure
Risk specific limits Limits referencing some special
feature of risk in question (e.g.,
liquidity ratios for liquidity risk)
Maturity/Gap Limits Limit amount of transactions that
mature or reset/reprice in each
time period
Concentration Limits Limits of concentrations of
various kinds (e.g., to individual
counterparties, or product type)
Greek Limits Option positions need to be
limited in terms of their unique
risk characteristics (e.g., delta,
gamma, vega risk)
Value-at Risk (VaR) Aggregate statistical number
Stress, Sensitivity, and Scenario These limits are based on
Analysis exploring how bad things could
get in a plausible worst-case
scenario. Stress tests look at
specific stresses. Sensitivity
tests look at the sensitivity of a
position or portfolio to changes
in key variables. Scenario
modeling looks at given real
world scenarios (hypothetical or
historical).
13 GARP (Global Association of Risk Professionals, 2020)
Example Weakness
Will not prevent future exposure, only
realized losses
Notional amount may not be strongly
related to economic risk of derivative
instruments, especially options
These limits are difficult to aggregate;
may require specialized knowledge to
interpret
These limits reduce the risk that a large
volume of transactions will need to be
dealt with in a given time frame, with all
the operational and liquidity risks this
can bring. But they do not speak
directly to price risk.
These limits must be set with the
understanding of correlation risks. They
may not capture correlation risks in
stressed markets.
These limits suffer from all the classic
model risks and calculation may be
compromised at trading desk level
without the right controls and
independence.
VaR suffers from all the classic model
risks and may be misinterpreted by
senior management. Specifically, VaR
does not indicate how bad a loss might
get in an unusually stressed market.
Varies in sophistication. Dependent on
deep knowledge of the firm’s exposures
and market behavior. Difficult to be sure
that all the bases are covered (e.g.,
there are endless possible scenarios).
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The active markets for exchange-traded instruments in the United States are:14
 Chicago Board Options Exchange (CBOE): active markets in equity and index options
 Philadelphia Options Exchange: leader in foreign exchange options
 International Securities Exchange (ISE), a leader in electronic trading of derivatives
 Chicago Board of Trade (CBOT): huge markets in futures on stock indexes, bonds, and
major commodities;
 Chicago Mercantile Exchange (CME): major markets in currency futures,
 International Monetary Market (IMM): options trading on futures on foreign currencies
and on bonds and interest rates.

14Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New
York: McGraw-Hill, 2014)

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