• Once a risk manager understands the firm’s risk appetite and has mapped its key risks, then he or she can decide how to best handle each risk.
• First, risk managers must define the most important risk exposures and make some basic prioritization decisions. Which risks are most severe and most urgent?
• Second, the firm needs to assess the costs and benefits of the various risk management strategies
  • Retain – Firms will want to accept some risks in their entirety or to accept part of a loss distribution. Note that retained risks are not necessarily small. For example, a gold mining company may choose to retain gold price risk because its investors desire such exposure. Alternatively, an input price risk that expresses itself as an expected loss can be retained and priced into the product. A key part of risk management is making carefully considered decisions to retain risk.
  • Avoid – Firms may want to avoid the types of risk that they regard as “unnatural” to their business. Some risks can only be avoided by stopping a business activity. Firms sometimes say they have “zero tolerance” for certain kinds of risk or risky behavior. But unless the right safeguards are in place, this sentiment may be more hopeful than descriptive.
  • Mitigate – Other risks can be mitigated in various ways. Examples include a firm asking for additional collateral to mitigate a credit risk and an airline investing in more efficient aircraft to mitigate its exposure to jet fuel price risk.
  • Transfer – Firms can transfer some portion of their risks to third parties. For example, insurance contracts and financial derivatives offer ways to transfer risks (at a financial cost).
• Senior management and the board will be responsible for selecting risk management strategies for larger risks. However, the risk manager needs to help them choose among the various options.
• It is rare for the costs of each strategy to be completely transparent. The cost of transferring the risk, for example, would ideally include the cost of employing a risk manager and the cost of managing any residual risks (e.g., basis risks). Meanwhile, a firm that hedges a commodity price might find that its competitors gain a short-term advantage from any fall in the spot price. Can it really put a number against that potential competitive weakness? While numbers are critical, a great deal of business judgment is also required.
• Finally, firms may have to conduct this kind of analysis for risks Some risks are harder to quantify than market risk, like technology risk and new insurable risks. For example, firms may need to estimate the size of a cyber risk loss through worst-case analysis and expert judgment.

Risk Transfer Toolbox

• In many cases, the risk manager will decide to transfer a portion of a financial risk to the risk management markets. The range of instruments available for hedging risk is can be categorized (broadly) into swaps, futures, forwards, and options. These instruments have been discussed in great detail later in this Curriculum. The following table gives a summary of the features of these tools –

• The use of these instruments requires firms to make key decisions based on their specific needs. For example, firms must decide how much they are willing to pay to preserve flexibility. Note that a forward contract provides price stability, but not much flexibility (because it requires the transaction to occur at the specified time and price). A call option provides both price stability and flexibility, but it comes with its own added cost (i.e., the option premium).
• Another key difference cuts across instrument types: trading mechanics. OTC and exchange-based derivatives have different strengths and weaknesses, particularly relating to liquidity and counterparty credit risk, which have been discussed in great detail in the third module – FMP.
• For many firms, interest rate risk is a major concern. Their fundamental task is to avoid taking on too much debt at high interest rates and avoid overexposure to variable rates of interest. This balancing act is determined by:
  • Each firm’s financial risk appetite, which may set out the levels of debt the board is happy with, and
  • The proportion of fixed interest to variable interest, (perhaps across several time horizons).

Hedging Operational And Financial Risks

• Hedging operational risk is concerned with the day-to-day activities of the firm like production (costs) and sales (revenue). Hence, operational risks are income statement risks, unlike financial risks, which are balance sheet risks (mainly related to assets and liabilities). Both assets and liabilities should be taken care of while hedging.
• Interest rate and foreign currency risks are critical areas of price risk management for many firms. The relationship between interest rates and foreign exchange rates is itself important. For example, should a firm raise money in the same currency as its overseas operations to minimize its exposure to foreign exchange risk? This may not be a practical option in some markets.
• For many firms, interest rate risk is a major concern. Their fundamental task is to avoid taking on too much debt at high interest rates and avoid overexposure to variable rates of interest. This balancing act is determined by:
  • Each firm’s financial risk appetite, which may set out the levels of debt the board is happy with, and
  • The proportion of fixed interest to variable interest, (perhaps across several time horizons).

• Even if the firm’s risk appetite remains stable, the rest of its risk management environment is constantly changing. These changes will come as the debt portfolio matures, business financing needs evolve, as well as when regulations and taxes change. More urgently, interest rates change and so do the relationships between rates across a range of maturities (i.e., yield curve risk). Examples of factors driving interest rate risk management in a constantly changing environment are given in this table
• Changes in interest rates are linked to the broader economy and consumer demand. They may affect the fundamental health of a business, including its ability to meet debt obligations. On the upside, the falling cost of servicing variable rate debt can offer an important natural hedge in a deteriorating business environment.
• A firm may also be exposed to foreign exchange risk. The first step here is to map out existing positions as well as contracts and other upcoming transactions. The firm then needs to develop a policy that dictates which exposures should be hedged. It also needs to set down the timing of the various cash flows as well as understand the assets and liabilities exposed to exchange rates. While individual transactions can be important, large firms have many financial exposures that balance and offset each other. In fact, the business activities of a large firm often create natural hedges (e.g., the inflows and outflows of foreign currency).
• Treasures meet this complex challenge by using a variety of instruments, such as OTC interest rate swaps and currency swaps. When formulating specific strategies, the risk manager should return repeatedly to the firm’s risk appetite and their directive. Often, that directive is to create a more stable version of the future around which the firm can plan.

Challenges During Corporate Hedging

1. A firm can misunderstand the type of risk to which it is exposed, map or measure the risk incorrectly, fail to notice changes in the market structure or suffer from a rogue trader on its team.
2. Risk management instruments like derivatives might not really be intended to manage risk. For example, swaps and other derivatives can be used to attempt to reduce the amount of interest paid, but in exchange, the hedger may be forced to take on much more downside risk or to alter the structure of the interest paid to minimize payments in the short-term in exchange for ballooning payments in the future. This kind of program is often more about artificially enhancing returns to meet analyst forecasts or covering up fundamental business problems than it is about true risk management. At worst, the program might be characterized by unnecessarily complex derivative structures, leverage, or strategies that turn sour after some superficially unlikely but entirely plausible event (such as an unexpected shift in interest rates or a rise in basis risk). This is not really a failure of risk management, but of corporate governance.
3. A purer cause of failure is poor communication about the risk management strategy and its potential consequences, especially if the market circumstances change. The classic example of this is perhaps the implosion of the MGRM (MG Refining and Marketing) hedging program in 1993. MGRM, the energy trading US subsidiary of Metallgesellschaft AG, had promised to supply end users with 150 million barrels of gasoline and heating oil over ten years at fixed prices. It hedged this long-term price risk with a supersized rolling program of short-dated futures and OTC swaps. The hedging strategy might well have worked if it had been pursued to the end. However, changes in the underlying oil market (i.e., a fall in cash prices and a shift in the price curve from backwardation to contango) meant that the program generated huge margin calls. As a result, MGRM’s startled parent company liquidated the hedges at a considerable loss. After that, the market reversed and moved against the now unhedged MGRM, resulting in even greater losses on its original customer commitments. Essentially, MGRM lost twice:
   • First, when it unwound the hedges at a loss due to the cash drain from the margin calls, and
   • Second, when the market moved against the original contracts (which were by then unhedged).
4. MGRM remains a lesson in the importance of thinking through the possible consequences of hedging programs and communicating the ramifications to stakeholders. If MGRM’s management had anticipated the potential liquidity impact of hedging with futures, they could have set aside enough capital to meet the margin calls and maintain the hedge. Or maybe they might have decided to hedge differently in a way that did not create so much liquidity risk from collateral calls
5. This table sets out some simple tips that might have prevented many corporate risk management disasters.