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Strategic Risk Management: A Case Study with Maple Leaf Foods James Ireland Senior Director, Risk Management Maple Leaf Foods
Lorne Hamilton Regional Director Reval
Agenda
• Framework for Best Practice Risk Management Policies
• Exposure Identification, Evaluation & Measurement
• Education, Communication, Validation • Measuring Your Success
Framework for Best Practice Risk Policies • Purpose and Value of a Risk
Management Policy • Components of an Effective Risk
Management Policy • Critical Success Factors in Developing
and Implementing a Risk Management Policy
Improving risk management policies is high on corporates list of priorities
Areas where treasurers see the greatest scope for development and improvement can be divided into cash management and risk management.
Source: PwC’s Global Treasury Survey 2010
Most Promising Developments in Treasury
Weather derivativesOther
OutsourcingAdditional Regulations
WebservicesIFRS – US GAAP convergence
Innovative financial solutionsBank industry consolidation
ERMSupply chain financing
Commodity risk managementPartnering with the business
Global bankingShared service centers
SEPACredit risk management tools
New technology/systemsPayment factories
SWIFT connectivityIn-house banking
Improving risk management policiesWorking capital management
Bank relationship managementCash forecasting
Risk Management Policy …
• Sets Strategic Principles defining – How risk is to be managed (Philosophy) – Which risks the company will be exposed to (Appetite) – The maximum amount of risk the company can be exposed to given its business
performance objectives and financial circumstance (Capacity) – The amount of risk it is willing to be exposed to (Tolerance) – An observable target (Objective)
• Delegates responsibilities and accountabilities for risk and risk management execution
• Defines the Risk Management Process – Measure, Manage, Monitor • Defines acceptable Risk Management Practices – Tool Box • Integrates into the overall Internal Control Framework
Strategic Principles Hierarchy
Philosophy
Appetite
Capacity
Tolerance
Objective
Each layer in a Risk Management Policy reduces the variability of expected outcomes
Unhedged Exposure
ILLUSTRATIONP
roba
bilit
y
Outcome
RiskCapacity
RiskTolerance
HedgeObjective
Risk Management Policies Delegate Responsibility and Accountability and Set Reporting Expectations
Board
Treasurer CFO CRO
Treasury
Business Unit
Business Unit
Business Unit
Del
egat
ion
Rep
ortin
g
Accountability for execution and results may lie with: • Treasury if business
risks are pooled • Business Units in a
decentralized model • Combination of the two
in hybrid models
Different audiences require different detail on the execution of a policy Performance Measurement & Reporting
To Treasurer/CFO: Transactions, Exposure variance, Market intelligence Hedge accounting results, Risk Measures, Sensitivity analysis
To Board: Valuations, Exposure summary, Hedge coverage ratios, Residual risk Actual vs. expected results, Policy compliance
To Treasury: Exposures, Transactions, Forecasts, Budgets Hedge Positions
Process Supports Business and Risk Objectives
Risk Appetite and Objective
Measure • Exposure Identification • Exposure Data Gathering
Manage • Risk Assessment • Risk Strategy • Trade Execution • Trade Processing
Monitor • Management Reporting • Financial Reporting
Business Mission, Goals and Objectives
Accountability Roles and Responsibilities
Policy and Procedures Technology
Risk Management Tool Box
Physical Contracts
Fixed Price
Floating Price
Embedded Derivatives
Term to Maturity
Derivative Contracts
Exchange Traded
Over-the-Counter
Futures, Forwards, Swaps
Vanilla Options
Exotic Options
Term to Maturity
Hedge Strategies
Match Hedge and Exposure
Calendar Spreads, Curve Risk
Basis Risk
Cross Commodity, Cross Currency
Hedging
Leverage
Risk Measures and Limits
Outright Exposures
Stress Tests, Sensitivities,
Deltas
Single Factor Probability
Measures (VAR, EAR, CFAR)
Multi-Factor Probability
Measures (VAR, EAR, CFAR)
Eligible Counterparties
Physical Suppliers
Banking Partners
ISDA Requirements
Credit Risk
Risk Management Policy must integrate with Internal Control Framework
• Ensure that risk management activities are being carried out and without adding new risks
• Detective controls Trade documentation Reconciliations Reporting Accounting/Audit
• Preventive controls Segregation of Duties Limits Systems - STP
Risk Assessment
Control Environment
Control Activities
Information & Communication
Monitoring
Control Framework
The segregation of duties is key to a policy’s success
Exposure Data
Gathering
Trade Approval & Execution
Position Management
Risk Management
Confirmation & Settlement
Accounting& Reporting
Front Office Middle Office Back Office • Collect and analyze exposure data • Recommend hedging strategies
to management • Monitor currency markets and news
and share insight • Determine hedges to execute • Execute approved hedge
transactions • Designate hedges for hedge
accounting and prepare hedge documentation
• Manage banking relationships
• Record and track trades • Monitor trade settlement requirements • Monitor derivative positions versus
limits and reconcile issues • Prepare management reports (e.g. ,
mark to market, position, performance) • Perform position analyses (e.g. stress
testing) • Manage counterparty and operational
risk
• Confirm trades with banks • Perform trade settlement function • Perform hedge effectiveness
assessment • Support accounting in preparing journal
entries • Review general ledger balances • Prepare appropriate external
reporting disclosures
A Robust Risk Management Policy provides the who, what, when and how for treasury
A risk policy can be viewed as providing an effective control framework around:
WHO • Trades • Approves • Monitors • Reports • Counterparty WHAT
• Exposures • Objectives • Strategy • Instruments • Benchmarks • Reports
WHEN • Decisions • Trading • Settlements • Communication
HOW • Objectives • Trading • Risk Analysis • Accounting • Valuation
What Risks do Policies Manage? • Policies are commonly developed to manage external risk - uncertainty due to
factors external to a company – Market risks: FX, IR, Commodity – Counterparty, Credit and Liquidity Risk
• Internal risk – risk of loss due to factors internal to a company - are often easier to affect – Operational Risk, Model Risk – Unauthorized activities, employee fraud, human error
• While we focus on the impact of external risks, the largest risk management failures are related to internal factors. As Risk Managers we need to be familiar with the lessons of – Metallegesellschaft AG, P&G vs Banker Trust, Orange County, Barings Bank
PLC, Long-term Capital Management (LTMC), Enron, Worldcom • Despite these pre-millennial lessons we continue to see similar failures.
Notable in the last 5 years: – Financial Crisis, European Debt Crisis, Jerome Kerviel (Societe Generale), MF
Global, JP Morgan’s London Whale
A well defined and implemented policy adds significant value to the business • Disaster avoidance:
• Front-page risk • Financial risk
• Regulatory:
• Sarbanes-Oxley • SEC • Board of Directors • Shareholders • Hedge Accounting / Auditors
Critical Success Factors • Take the time to put a solid infrastructure/risk management policy
framework in place – Establish a Risk Oversight Committee – Hire personnel with requisite skills/knowledge and/or outsource – Acquire appropriate systems/data
• Develop Strategic Principles (Philosophy, Appetite, Capacity, Tolerance, Objectives) for Risk Management
– Manage by objectives – otherwise how will you know if you were successful • Clearly delegate accountability for performance of Risk
Management objectives • Select the correct tools for your organization • Integrate Risk Management into your Internal Control Framework Remember • Don’t file your risk management policy away • Communicate!!!
Exposure Identification, Evaluation and Measurement • Definition of Risk • Types of Risks • Risk Measurement • Risk Assessment Process
How do you define risk? • Exposure to uncertainty/variance to possible outcomes • Typically viewed as potential for a negative impact • Anything that impacts the ability to meet business
objectives/strategy Pr
obab
ility
of O
utco
me
Possible Outcomes
Variance Below Expected(Potential Negative Return)
ExpectedOutcome
Variance Above Expected (Potential Positive Return)
Risk management is a process to identify, assess and manage risks to bring them to within acceptable levels
There are many different types of financial risk
Financial Risks
Financial Risk:
“Changes in financial market rates or
variability impacts the Company’s ability to
achieve its objectives.”
Foreign Currency Exposures
Cash Collection
Transaction exposure (Forecast)
Translation exposure (BS and P&L)
Transaction exposure (Committed)
Product Shipped (sale and receivable
recorded)
Product Order (firm
commitment)
Annual Plan Set/Product Prices Set
Financial Forecasting
Long-term
Business Planning
Earnings Impact (AR/AP) Cash flow impact;
Impact vs. budget or prior yr.
Economic Exposure
Interest Rate Exposures Volatility in interest rates can have substantial impact to: • Balance Sheet
– Value of financial assets/liabilities: • Fixed rate investments • Fixed rate debt/refinancing • PV of pension liabilities
– Equity value • Income Statement or Cash Flow
– Interest expense (variable) – Interest income – reinvestment risk of cash investments – Refinancing/rollover risk of debt
Commodity/Energy Exposures Primary Categories • Direct Exposures (visible)
– Inputs to production/COGS – Energy consumed in service/production
• Indirect Exposures (less visible) – Embedded product components – Surcharges, e.g. fuel price surchage
• Basis Risk – Underlying commodity price vs. your final cost
Credit/Counterparty Exposures • Credit risk – risk that the issuer/counterparty to an obligation may default, or will be unable
to make timely payments on the obligation – Investors are more concerned with changes in the perceived credit risk of an
issuer/counterparty since this impacts the valuation of their investment through the adjustment of the credit spread
Situation Risk Metrics
Fixed Income Investment Risk of default on principal/interest payments Yield spread to risk-free rate
Bank Relationship Risk to cash balances, or performance on credit facility
Credit rating, bond yield spread, or credit-default swap (CDS)
Derivative Counterparty Risk of default on obligation Potential future exposure (PFE)
Account Receivable Risk of customer pmt. default Aging of receivable, credit profile of customer
Supplier Ability to perform as needed Credit rating, yield spreads, profile of supplier
Risk management must adapt and consider new information and risks
49.7%
58.4%
22.0%
32.8%
24.0%
36.5%
17.6%
17.6%
41.6%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
After Crisis
During Crisis
Before Crisis
High Medium Low
Importance of Counterparty Risk Management
44.6
%42
.4%
50.9
%
9.4%
10.3
%
6.9%
6.1%
6.1%
3.6%
23.0
%23
.7%
10.5
%
10.6
%11
.6%
22.1
%
6.3%
5.9%
5.9%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
After Crisis
During Crisis
Before Crisis
Published Ratings Equity Prices Bond Yield CDS Spreads Not Monitored Other
Approach to Counterparty Risk Management
• Counterparty risk has become more important • Treasurers looking beyond published credit ratings • Approach to counterparty risk measurement more sophisticated
Identifying and collecting exposures is the hardest part • Rely on existing resources (sales forecasts, payroll budgets, historical AP/AR, procurement estimates)
• Decentralize input with review/approval process to clean data
• Update on business cycle and not treasury cycle (quarterly sales updates or other timeframes that are in line with the business environment)
• Record history and compare actual vs. expected. Feed into hedge policy targets and internal feedback to operations
• Look for offsets to identify net exposures
A hedging strategy must consider the effects of time • Target Hedge Ratios
– Layer over time – Top-up
• Hedge Duration Horizon – FX/Commodity
– 1 to 3 years or life of program – Interest rate
– Life of debt instrument – Business/risks change over time
• What are Company and Stakeholder Objectives
There are many tools and models to evaluate risk Risk measurement methodologies range from the simple to more complex. The methodology used is directly linked to your situation and your risk management group’s available tools.
Stress-Test/ Scenario Analysis
Data and Modeling Requirements
Valu
e
Static Forecast
Historical Simulation
Monte Carlo Simulation (VaR/CFaR/EaR)
Scenario Analysis/Stress Testing is a very common approach
• Simple – Linear – Focus on likely events and
extreme scenarios – View stress points, e.g.
financial distress levels or risks to budgets
• Pros – – Visibility to basic assumptions – View alternative paths/pain
points – No forecast/probabilities – View pre-hedging (inherent
risk) and post-hedging (residual risk)
• Cons – – Don’t know what may occur -
may underestimate risks
Exposure to US$ per Foreign CurrencyExchange Rate
(-) U
S$ E
quiv
alen
t Rev
enue
(+)
Scenario AnalysisUS$ Equivalent Revenue
US$ Appreciates /Foreign Currency Depreicates
US$ Depreciates /Foreign Currency Appreciates
Illustration
“Scenarios enable you to think about possible outcomes in a systematic fashion – if you’re wrong on your forecasts, then what are the consequences?” R.Bookstaber
Is Value-at-Risk the right tool for you?
• Value-at-Risk (VaR) – Summarizes total risk in a
portfolio of financial assets/liabilities, e.g. “how bad can things get”
– Focused on valuations
• Pros – – Visibility to many alternative
paths and extreme situations – Single number ($-value)
• Cons – – Short-term focused – Other limitations
OutcomePr
obab
ility
VaRAt 95% C.I.
5% Risk
Expected V
alue
VaR estimates the probability that a given loss might occur. For example, 95% confident that will not lose more than $10M over next 1-day horizon, or 5% chance of losing more.
Cash Flow at Risk and Earnings at Risk may be a better model for most businesses
• Similar to VaR, but focuses on cash flows or earnings over a longer period of time
– More relevant for the corporate risk manager
• Answers question: how large deviation b/w planned cash- and actual cash-flow could be
• CFaR measures the cash that would be paid or received with X% certainty over a given time period, for example:
– 95% confident that cash expense, e.g. due to commodity prices, will not exceed $300M over next 6-months.
$200M
Prob
abili
ty
CFaRAt 95% C.I.
5% Risk
Expected E
xpense
$300M $100M
Potential Worse-Case Variance to Expense
Cas
h Fl
ow
Time
6-Months
12-Months
Cash Flow
At R
isk vs.
Expected
Minimum Level
Using Models has Pros and Cons Cons/Limitations - • Function of:
– Time – Confidence level
• Assumes a normal market – Perfect competition assumptions
may be violated – Financial returns are typically
skewed, e.g. fat tails – Cross asset correlations jump
towards 1 under crisis situations • Risk of “false precision” • Times change; we live in a
random world
Pros/Benefits - Adds objectivity to analysis
process and decisions See many possible paths View pain points (risk tolerance
level) View trend in risk metrics Can be employed before and
after hedging to see risk reduction
Models are just tools. Which model is best for you depends on what you’re trying to measure; you may need a combination of models.
You must create a process for assessing Risk
Understand Current
Exposures
Develop Process
Evaluate Exposures
Key Activities • Define financial risk
exposures • Define metrics for each
exposure type • Formulate initial view as to
nature and magnitude of each exposure type
• Perform initial analysis of how exposures impact objectives
Key Activities • Stress test exposure
forecast • Reconcile actual to
expected results • Model expected variability
based on history • Review exposures
regularly, e.g. quarterly
Key Activities • Design exposure data
gathering process • Develop information sources Use business units Sales forecasts Purchase history
• Assign accountability Regular updates Monitor expected forecast
slippage
Build risk identification process into business planning process.
How do you measure success?
• Hedge performance measurements:
Critical Success Factors • Leading companies look at risk systematically • They know what their risks are/understand their exposures • The evaluate risk both discretely and on a portfolio basis • They have a robust process in place to identify and assess
risks • Risks are well understood and communicated throughout
the organization using dashboard or other standard reports • Assign accountability for exposure identification & updates
– Forecast accuracy – Updates to forecast – Reconcilement to actual results
Case Study: Maple Leaf Foods
• Building a strong risk management framework and culture is an evolutionary process.
• The foundation is a strong policy framework that: – Sets strategic principles – Assigns accountability – Defines the risk management tool box
• The principles must then be consistently applied in a manner that encourages the adoption of more robust risk measurement practices and hedge design.
Strategic Principles Hierarchy
Philosophy
Appetite
Capacity
Tolerance
Objective
Risk will be managed first by cost pass-through to customers and, where that is not possible, using
appropriate physical and derivative contracts.
Risk must not exceed the levels needed to support planned activities. Risk Management activities will
not increase exposure beyond those levels or reverse the direction of those exposures.
Losses cannot threaten solvency and longer term corporate targets.
Limit the probability/size of losses to “reasonable” levels while maintaining participation in favourable market moves (to meet/exceed annual budget and
bonus performance targets).
Ensure that costs/revenue do not exceed/fall short of “X” with probability “Y”.
Risk Management Policies Delegate Responsibility and Accountability and Set Reporting Expectations
Del
egat
ion
Rep
ortin
g
Board
Treasury
Business Unit
IR, FX Back/Middle Office Market Risk Policy Credit Risk Policy
Ag Commodities
Risk Management Committee CEO, CFO, Treasurer, VP Commodity Risk
CEO
CFO Chief Food
Safety Officer
Inte
rnal
Aud
it
Chief Human Resource
Officer
Food Safety Human Resources
Internal Controls
Com
plia
nce
Other Commodities
Counterparty Risk
Risk Management Tool Box
Physical Contracts
Fixed Price
Floating Price
Embedded Derivatives
Term to Maturity <12M
Derivative Contracts
Exchange Traded
Over-the-Counter
Futures, Forwards, Swaps
Vanilla Options
Exotic Options
Term to Maturity <12M
Hedge Strategies
Match Hedge and Exposure
Calendar Spreads, Curve Risk
Basis Risk
Cross Commodity, Cross Currency
Hedging
Leverage
Risk Measures and Limits
Outright Exposures
Stress Tests, Sensitivities,
Deltas
Single Factor Probability
Measures (VAR, EAR)
Multi-Factor Probability
Measures (VAR, EAR, CFAR)
Eligible Counterparties
Physical Suppliers
Banking Partners
ISDA Requirements
Credit Risk
Execution Challenges • Exposure Reporting
– Risk Management programs require frequent and accurate updates of both committed exposures and changes to forecast exposures.
– In most cases, Treasury must rely on Business Unit Finance and Planning processes which are geared to external financial reporting and budgeting timelines.
– Ensure that people understand why they are reporting exposures – you could be in for a surprise!
• Introducing the concepts of Risk Tolerance and Risk Based Targets – Getting Business Units to express a risk tolerance around budget/current prices, measuring
market volatility and hedging to stay below a fixed probability of exceeding that risk tolerance are the three most effective steps to improve the consistency and performance of a risk management program.
• Risk Identification – Hedging committed exposure versus anticipated/budgeted exposures – Dealing with seasonal event risks – Dealing with the structure of input and output markets
Beat “Better-than-Budget”
When is an Exposure a Risk? • Hedging the FX risk of a known future foreign currency cash flow is
straight forward. Hedging anticipated flows is more complex. • If the future price of the anticipated flow changes with the exchange
rate, there is no FX risk until contract is finalized. Hedging by selling the foreign currency forward at the anticipated stage increases risk and generally reverses its direction.
• Looking back at our Strategic Risk Principles, this form of hedging is not allowed!
• However, if we can demonstrate that the impact of exchange rate changes cannot be passed on to the customer/supplier, hedging anticipated exposures should be part of our risk management program.
• It’s never that simple: – A common view of the impact of Gate Price Tariff systems, is
that purchaser’s bargain with suppliers over the landed foreign currency price of goods fixed at the Gate Price Level) and that the seller is exposed to all FX risk (Top Slide)
– However, if we assume that purchaser’s bargain over prices in the supplier’s domestic market, contracted prices will reflect the supply and demand conditions in the supplier’s market and the FX rate at the time of sale (Bottom Slide)
• In the former case hedging is required, in the latter it isn’t!
Seasonal and Market Factors • Seasonal and Market factors must be taken account of in the execution of your risk
management strategies. Largely this is an issue of identifying peak periods of risk throughout the year. These are not risks easily captured in VAR, EAR, CFAR models but are treated easily through historical simulation and scenario analysis.
• Commodity exposures are subject to strong seasonal trends and event risks and may
influence the timing and types of hedges employed – Natural Gas prices are dominated by residential heating demand peaking demonstrating
price peak in Dec/Jan and volatility spikes in Feb/Jul. – Lean hog prices demonstrate strong summer seasonal peaks corresponding to the North
American peak demand. – Wheat prices are subject to weather risk which is generally realized over the coarse of June
through July.
• Market structure will also influence hedge structure and term to maturity – Can customers set the pace and size of pricing increases in the market? – Are there a limited number of competitors in the market? Do I need to be aware of how my
competitors hedge programs are performing? – In a highly competitive market (many buyers and sellers), this is likely to be less of an issue.
Questions? Reval is a leading, global Software-as-a-Service (SaaS) provider of comprehensive and integrated Treasury and Risk Management (TRM) solutions. Our cloud-based software and related offerings enable enterprises to better manage cash, liquidity and financial risk, and includes specialized capabilities to account for and report on complex financial instruments and hedging activities. The scope and timeliness of the data and analytics we provide allow chief financial officers, treasurers and finance managers to operate more confidently in an increasingly complex and volatile global business environment. Using Reval, companies can optimize treasury and risk management activities across the enterprise for greater operational efficiency, security, control and compliance. Founded in 1999, Reval is headquartered in New York with regional centers across North America, EMEA and Asia Pacific. For more information, please visit www.reval.com or contact [email protected].
For more information, contact:
Lorne Hamilton, Regional Sales Director, Reval
416.622.2338
James Ireland, Senior Director Risk Management, Maple Leaf Foods
416.926.7089
