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Home > Financial Risk Management Best Practice > A Total Balance Sheet Approach to Financial Risk

Financial Risk Management Best Practice

A Total Balance Sheet Approach to Financial Risk

by Terry Carroll

Executive Summary

  • Because the oil price rose rapidly and the wider commodities market followed suit, inflation rose to its highest level for many years. Following a protracted boom, property prices have been savaged. Only interest rates have remained comparatively benign.

  • Protecting or insulating yourself or your company against financial risks is known as “hedging.” Most businesses use a transaction-driven approach. The generic name often used by bankers for these hedging instruments is “treasury products.”

  • Bankers can provide a derivative-based hedge to reduce or neutralize an interest rate, inflation, or commodity price risk. A derivative is a financial instrument whose value changes in relation to an underlying variable such as interest rates, commodity prices, or house prices.

  • Price increases and currency fluctuations, as well as interest rate movements, can be hedged. The most common source of long-term capital, fixed by nature, is retained profits. A mismatch between, say, fixed-rate assets and variable-rate liabilities may cause you to want to hedge or renegotiate more fixed-rate liabilities to produce a better match and more overall certainty, with, by definition, lower overall risk.

Introduction

We are living in some of the most volatile times in the history of the global financial markets. One of the reasons is exactly because they have become truly global. As banks seek to restore profitability, they may increase their offering of “treasury products” to customers. This article argues that these should be considered only in the context of a total balance sheet approach rather than transaction by transaction.

Managing Increased Financial Risk

We have seen a period in which the oil price rose to $147 a barrel and then fell back dramatically. The wider commodities market followed suit. Inflation rose to its highest level for many years before easing back. Property prices have been savaged, following a protracted boom. Only interest rates have remained relatively benign compared to the extremes of the past.

Volatility has been traded as a market index for many years, but in 2008 alone it hit several spikes. It has become a fact of life. Markets are now driven mainly by fear—fear of being caught out when prices fall or fear of not being in the market as prices rise. Add to that the power of short sellers and you have a scary scenario for borrowers and investors, whether individuals or corporate.

Protecting or insulating yourself or your company against financial risks is known as “hedging.” The principle of hedging is easily understood—it’s like an insurance premium. In practice, the instruments generally used are known as “derivatives.” These are poorly understood and, given the recent financial mess, probably viewed with fear or trepidation.

This article attempts two things: first, to put forward a more objective approach for companies wishing to improve their financial efficiency at a managed level of risk; and second, to demystify financial risk, making it a more approachable topic for the average manager or director.

What Is a Derivative?

A derivative is a financial instrument whose value changes in relation to an underlying variable, for example: interest rates, the rate of inflation, commodity prices, share or bond prices, house prices, etc. Its most general use is for the purpose of “hedging” a given risk, i.e. neutralizing or taking the opposite position to a given risk, such as commodity prices, exchange or interest rates.

The problem with derivatives is that although they were created for the primary purpose of insuring against financial risks, the proportion of derivatives trading done for speculative purposes now dramatically outweighs that for ordinary trade purposes.

Most Hedging Is Transaction-Based

In this article we shall be proposing a “full balance sheet approach” to the management of financial risk. Most businesses currently use a transaction-driven approach. This could result in overall risk being increased rather than decreased.

By a transaction-driven approach, we mean that each transaction or set of similar transactions is individually hedged. This is the most common situation, whether the use of derivatives is recommended by a bank or requested by the customer. The generic title often used by bankers for these hedging instruments is “treasury products.”

Trading and managing the use of derivatives is a highly skilled and often complex process. They are usually created and dealt with by the treasury or special products division of a bank. In the United Kingdom, these “rocket scientists,” as they are sometimes known, are usually based in the City of London, embedded within the financial markets.

If you wish to hedge a risk, your bank will usually put you in touch with such a treasury specialist. Alternatively, the bank may make the first move. Not surprisingly, banks have increasingly been offering these products in the climate of increasing volatility for all the commodities and financial facilities that companies use.

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Further reading

Books:

  • Choudhry, Moorad. Bank Asset and Liability Management: Strategy, Trading, Analysis. Singapore: Wiley, 2007.
  • Van Deventer, Donald R., Kenji Imai, and Mark Mesler. Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. Singapore: Wiley, 2005.

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