Derivatives and Risk Management in Mexico

Risk Management in Mexico: a Business Perspective

Eduardo Cepeda, Presidente y Director General, JPMorgan Chase México.

May 8, 2001

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Key Ideas

• Managing risk is not specutlation

• The decision to do nothing is an active decision

• To choose to be unaware of risks and tools to manage risk can be costly

• Mexican corporations can do more to actively manage risk

• Changes in the regulatory framework of Mexican banks, insurance companies and pension funds will hopefully make the tools necessary to manage risk more accessible

• Need to promote a risk management culture

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Key Risk Management Functions

• Identify– Catastrophic– Commodity– Interest Rate / Currency– Liquidity– Credit– Legal / Liability– Operational

• Measure – Probability– Impact

• Financial• Tax• Accounting

– Tolerance

• Report– Management– Investors– Regulators

• Define– Objectives– Limits– Responsibilities

• Act– Insure– Hedge / Mitigate

• Derivatives• Diversification• Restructure

– Do nothing

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Risk management is an ongoing function as opposed to a one time activity

• Risks change and must therefore be monitored and measured continuously– new risks– small risks become large ones meriting closer attention and vice versa

• Many aspects of hedging tools must be understood – tax, accounting and legal implications– hedge effectiveness

• The portfolio of risks and hedges must be measured constantly to monitor changes in underlying assumptions and measuring systems must be continuously updated– Garbage in - Garbage out

• Management and regulators should be updated frequently to insure objectives and limits remain appropriate

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Sample risks and potential management tools

Sample Risks Potential Management Tools

Production stoppages from disasters…………………………….. Insurance

Drop in value of products sold…………………………………….. Commodity and FX derivatives

Increase in cost of raw materials………………………………….. Commodity and FX derivatives

Drop in value of interest income and investments………………. IR and FX derivatives

Increase in value of interest expense and liabilities…………….. IR and FX derivatives

Drop in value of equity portfolio…………………………………… Equity derivatives

Accidental destruction of fixed assets……………………………. Insurance

Litigation…………………………………………………………… Insurance

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Sample risk profiles of Mexican corporations:Tools are available to hedge these risks

MXN/USD

Exporter to the US

FIRE

Any Organization

Price of Crude

Pemex Floating rate debt payer

Interest Rates

NO FIRE

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Risk management developed in tandem with the appearance of risk and the tools to manage them

• Catastrophic risks and the insurance that covers them have been around for a very long time

• Relative currency and price stability until the early 1980’s

• Relative interest rate stability until the early 1980’s

• Lack of tools to hedge interest rate and currency risks until the 1990’s

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Mexico has suffered greatly in the past from not managing risks

• Late 1970’s over-investment in oil followed by the crash in oil prices leading to the financial crises that lasted a decade

• Early 1990’s excessive currency and credit risks assumed by the recently re-privatized banks in their race to justify their valuations

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Current efforts aimed at improving risk management in Mexico

• New CNBV guidelines for risk management at banks

• Development of a local market for derivatives– listed and over the counter

• Further development of documentation for local derivatives

• Clarify the accounting and tax treatment of derivatives

• Risk management guidelines for insurance companies, mutual funds and Afores– Currently these guidelines restrict and even prohibit the use of derivatives

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Circular 1423 of the CNBV sets the guidelines for Risk Management for Banks

• Effective February 1st 1999, it is the first time Regulators address Risk Management issues for Mexican banks

• The key objective was to promote a Risk Management culture

• Set minimum guidelines for identifying, measuring, monitoring, limiting, controlling and reporting risk

• Established the function of the Unidad Integral de Riesgos (UAIR)

• Set guidelines for a Risk Committee, disclosure reports and manuals

• Set responsibilities of the Director General– maintain independence between risk and business managers– promote a risk management culture

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The UAIR has the function of controlling the key risks defined in Circular 1423

Credit Department

Legal Department

Operations Department

Business Areas

UAIR

Credit Risk

Legal Risk

Operations Risk

Market and Liquidity

Risk

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Risk Management at JP Morgan Chase Mexico

Risk Management has been defined as the sum of:

objectives, politics, procedures, processes and actions

implemented to

define, measure, limit, control, inform and disclose

the various forms of risk facing JP Morgan Chase Mexico