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FX Risk Management – Best Practice Standards for Good Corporate Governance - by Derrick Ryley, Partner, PricewaterhouseCoopers
Citation preview
PricewaterhouseCoopersFRM 1011
Derrick Ryley
FX Risk - Managing and Measuring
19 March 2002
PricewaterhouseCoopersFRM 1012
AgendaAgenda
• Dimensions of risk that needs to be managed• Establishing a risk control framework• Ensuring Control of FX and associated risks• Observations and final considerations
PricewaterhouseCoopersFRM 1013
Who Creates RiskWho Creates Risk
Agri Business• Policy -Hedge 100% of sales
• Directors
• GM Finance
• Head trader
• CFO
PricewaterhouseCoopersFRM 1014
Who Creates RiskWho Creates Risk
Agri Business• Policy -Hedge 100% of sales
• Directors
• GM Finance
• Head trader
• CFO
PricewaterhouseCoopersFRM 1015
Who Creates RiskWho Creates Risk
Bank• Policy –VAR not greater than
$X million
• Directors
• GM Finance
• Head trader
• CFO
PricewaterhouseCoopersFRM 1016
Who Creates RiskWho Creates Risk
Bank• Policy –VAR not greater than
$X million
• Directors
• GM Finance
• Head trader
• CFO
PricewaterhouseCoopersFRM 1017
Who Creates RiskWho Creates Risk
Gold Company • Policy -Hedge X% of projected
production
• Directors
• GM Finance
• Head trader
• CFO
PricewaterhouseCoopersFRM 1018
Who Creates RiskWho Creates Risk
Gold Company • Policy -Hedge X% of projected
production
• Directors
• GM Finance
• Head trader
• CFO
• Mine Manager
PricewaterhouseCoopersFRM 1019
Who Creates RiskWho Creates Risk
Power Company• Policy -Hedge not less than
100% of committed sales
• Directors
• GM Finance
• Head trader
• CFO
PricewaterhouseCoopersFRM 10110
Who Creates RiskWho Creates Risk
Power Company• Policy -Hedge not less than
100% of committed sales
• Directors
• GM Finance
• Head trader
• CFO
• Salesman/weather
PricewaterhouseCoopersFRM 10111
“Operational risk is the risk of direct or indirect loss resulting from
inadequate or failed internal processes, people and
systems or from external events”
What is Operational Risk?
There is a general consensus on what operational risk is:
PricewaterhouseCoopersFRM 10112
Common risk view
Understanding dependencies
Info
rma
tio
n
De
cis
ion
s/d
irec
tion
(e.g
., c
on
trols
or fu
nd
ing
)
Current approaches to management are fragmented
Current approaches to management are fragmented
Corporate Risk
Compliance
Customer Service
Audit
Data ProtectionFraud IA
Testing
Transaction Monitoring
Physical Security
IT Security
A View of the Current Approach to
Risk Management
An Integrated, Enterprise-wide Approach to Risk Management
PricewaterhouseCoopersFRM 10113
Ten questions to ask about your operational risk processTen questions to ask about your operational risk process
• Is the full scope of operational risks being proactively analyzed?
• Is there accountability for each types of operational risk?
• Are issues being identified, analyzed and understood?
• Are service/quality expectations being met?
• How much does operational risk cost the organisation?
• Is senior management rewarded for good performance?
• Are risks being addressed with a suitable focus on alternatives and cost/benefits?
• Is management being supportive and creating the right culture?
• Are issues raised being analyzed and addressed?
• Do we communicate standards to our stakeholders?
PricewaterhouseCoopersFRM 10114
Event
EffectCause
The industry is moving to a common language for operational risk
PricewaterhouseCoopersFRM 10115
Event
EffectCause
Sales Practices Transaction Processing Criminal activities Unauthorized activities Technology Human Resources Vendor and External Dependencies Management Process Disasters Product
Event definitions are based on what happened and where
PricewaterhouseCoopersFRM 10116
Event Effect
CauseImpact to Expenses
Legal Cost/Settlement
Regulatory/ Compliance
Restitution Loss of recourse Write-downs Loss of Physical
Asset
Any event can have multiple effects
Impact to revenue/margin
Service Levels Foregone
Income Quality Reputation Business
Interruption
PricewaterhouseCoopersFRM 10117
Event
EffectCause
Internal Controls Policies & Procedures Management Oversight Hiring & Training Turnover Automation Information Malice
Causes indicate what controls went wrong permitting the event to occur
PricewaterhouseCoopersFRM 10118
Qualitative criteria exist to advance to each step Qualitative criteria exist to advance to each step
Basic Indicator Approach
StandardizedApproach
AdvancedMeasurement
Approach
EffectiveRisk
Managementand Control
Measurementand
Validation
None Independent op risk management
Use of risk reporting
Active board of directors/Senior Management
Documentation of risk systems
Audit review of process
Risk management is conceptually sound and has integrity
Sufficient resources
Integration into reporting, capital, risk analysis
Use in day-to-day activities
Loss database and 3-5 year history
99.9% level of confidence
Scaling of internal/external data
Consistent process
Rigorous process for including external data
Capture tail risk
Stress/scenario testing
Disciplined over-ride process
Risk reporting to support data for capital
Tracking risk and loss data
Mapping of event categories and business lines to standard framework
PricewaterhouseCoopersFRM 10119
Establishing a risk control frameworkEstablishing a risk control framework
• Organisation
• Policy
• Risk Indicators
PricewaterhouseCoopersFRM 10120
Board of Directors
Internal AuditSenior
Management
Operational Risk Committee
Chief Risk OfficerBusiness Unit Management
Business UnitsOperational Risk
Staff
Operational Risk Related Staff Functions
•Compliance•Human Resources•Insurance•IT•Legal
Head of Operational Risk
Head OfficeOperational Risk
Staff
The management structure is characterized by a head of operational risk reporting to the Chief Risk Officer.
PricewaterhouseCoopersFRM 10121
Risk Management Organizational ModelRisk Management Organizational Model
Risk Management Approach and
Strategy
Risk Management Directives
Risk Management Implementation and Monitoring
Risk Identification, Assessment,
Mitigation and Reporting
Risk Management Program Testing
Executive Management
Risk Management Committee
Chief Risk Officer
Business Units
Internal Audit
Board of DirectorsRisk Management
PhilosophyThe responsibility for risk management rests with the business units which will be supported by guidance from the Board of Directors and senior management. Proposed responsibilities are as follows:
PricewaterhouseCoopersFRM 10122
• Provide clear guidance and communication about the definition of risk.
• Ensure linkage to the company’s overall business objectives.
• Reduce the possibility of miscommunication and possible errors in the management of the foreign currency program.
• Define what and when.• Ensure that the company’s risk management objectives
are met and that the hedging strategy is well executed.
Policy
PricewaterhouseCoopersFRM 10123
Exposure IdentificationExposure Identification
• Transactional exposure– Explicit exposure (event has occurred)
– Implicit exposure (event is scheduled/forecast to occur)
• Translation or Balance Sheet exposure (FX Subsidiary)• Economic or Operating exposure (embedded in business)
PricewaterhouseCoopersFRM 10124
Exposure MeasurementExposure Measurement
• Who is responsible?– generally treasury
– may be coordinates
– must be risk committee
• Data needs– large, see later slides
• Timing– at least monthly or more frequent
– following major change event
• Tools– usual, VAR, MtM, Credit, Stress Testing, Scenario testing
PricewaterhouseCoopersFRM 10125
operational risk has two dimensions ofOperational
Risk
People & Culture Business Process
Control Survey
Control Environment
Risk Assessment
Control Activities
Information & Communication
Monitoring
Objective, Risk & Control Alignment
Define Objectives
Action Planning/ Accountabilities
Assess Risks
Analyze Controls
"Soft Controls" "Hard Controls"
Risk Indicators
PricewaterhouseCoopersFRM 10126
. . . Only if someone follows-up
“What gets measured gets done . . .”
Risk Indicators
PricewaterhouseCoopersFRM 10127
Most companies have data overload yet little insight into progress toward strategy or understanding of current operational related risks . . .
– Indicators are additive and not prioritised or rationalised – Use what is readily available, not what is insightful– Data is often lagging not leading– Risk indicators do not have a context - few firms have an operational risk framework and there is little to no relationship of operational risk measures to key management reporting measures or compensation– Finally, there is no proven correlation between risk and indicators - so results are discounted
Risk Indicators
PricewaterhouseCoopersFRM 10128
Asset and Liability ManagementAsset and Liability Management
Definition:“Asset/Liability Management is the set of actions and procedures designed to co-ordinate the
organisation’s overall and individual business units contribution to its risks and financial position”
Duties:1. Devise and review strategies to maximise earnings and return on capital within agreed and
measured levels of risks;2. Monitor and discuss the status and results of agreed ALCO strategies and tactics;3. Review outlooks affecting individual business units’ risk profile and contribution to revenue;4. Review the current and prospective positions and monitor potential structural or market
changes that can affect liquidity;5. Review measurements reports on identified risks, including simulated exposures of risks to
limits, asset mix/quality, credit, and impact of market shifts on overall organisation risk and financial position;
6. Develop parameters for pricing;7. Provide for regular formal review of ALCO “model risk” assumptions, including an
appropriate training for ALCO members, executive management and the Board of Directors.
PricewaterhouseCoopersFRM 10129
Reporting No FX Risk ?Reporting No FX Risk ?
Base Gap
-150
-100
-50
0
50
100
150
Sales
Purchases
Spot
PricewaterhouseCoopersFRM 10130
Reporting No FX Risk ?Reporting No FX Risk ?
Pessimistic Gap
-150
-100
-50
0
50
100
Sales
Purchases
Spot
PricewaterhouseCoopersFRM 10131
No FX Risk No FX Risk
Normal Sales
-40
-20
0
20
40
60
80
100
120
140
160
Jul-0
2
Sep-0
2
Nov-0
2
Jan-
03
Mar
-03
May
-03
Jul-0
3
Sep-0
3
Nov-0
3
Jan-
04
Mar
-04
May
-04
Sales base
Purchases
Spot
Profit
PricewaterhouseCoopersFRM 10132
No FX Risk No FX Risk
Sales/Pessimistic
-60
-40
-20
0
20
40
60
80
100
120
140
160
Jul-0
2
Sep-0
2
Nov-0
2
Jan-
03
Mar
-03
May
-03
Jul-0
3
Sep-0
3
Nov-0
3
Jan-
04
Mar
-04
May
-04
Sales base
Spot
Profit Base
Sales Pessimistic
Profit Pessimistic
PricewaterhouseCoopersFRM 10133
Lets look at FutureLets look at Future
Alco Gap Base
-100
-50
0
50
100
150
Jul-0
2
Aug-0
2
Sep-0
2
Oct-
02
Nov-0
2
Dec-0
2
Jan-
03
Feb-03
Mar
-03
Apr-0
3
May
-03
Jun-
03
Jul-0
3
Aug-0
3
Sep-0
3
Oct-
03
Nov-0
3
Dec-0
3
Jan-
04
Feb-04
Mar
-04
Apr-0
4
May
-04
Jun-
04
Sales
Purchases
Spot
PricewaterhouseCoopersFRM 10134
Lets look at ProfitLets look at Profit
Profit Ranges
-150
-100
-50
0
50
100
150
200
250
300
350
400
Jul-0
2
Sep-0
2
Nov-0
2
Jan-
03
Mar
-03
May
-03
Jul-0
3
Sep-0
3
Nov-0
3
Jan-
04
Mar
-04
May
-04
Base BaseBase HighBase LowOpt BaseOpt HighOpt LowPess BasePess HighPess Low
PricewaterhouseCoopersFRM 10135
Lets look at ProfitLets look at Profit
High/Expected/Low
-150-100
-500
50100
150200250300
350400
Jul-0
2
Sep-0
2
Nov-0
2
Jan-0
3
Mar-0
3
May-
03
Jul-0
3
Sep-0
3
Nov-0
3
Jan-0
4
Mar-0
4
May-
04
High
Base
Low
PricewaterhouseCoopersFRM 10136
Increasing sophistication and data requirements
1. Rate Sensitive Imbalance (Rate Sensitive Assets Less Rate Sensitive Liabilities
2. Maturity/ Repricing Gap Analysis
3. Duration Analysis
4. Simulation of Net profit and Market Value of Portfolio
The ability to assess the economic impact due to changes in FX exposure has become more sophisticated over time
RX Risk Management
PricewaterhouseCoopersFRM 10137
ConclusionConclusion
• Look at organisation as whole • Do not limit your horizons to treasury
– The sales man could take you down– The banks sales man could take you down
• Engage the GM’s at all level’s, the mine manager could effect you
• There is no one solution, it should be within a range• Influence the upside• Cost and protect the downside• Put proper process in place• Educate• Educate
PricewaterhouseCoopersFRM 10138