FX Risk Management – Best Practice Standards for Good Corporate Governance

PricewaterhouseCoopersFRM 1011

Derrick Ryley

FX Risk - Managing and Measuring

19 March 2002


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


Who Creates RiskWho Creates Risk

Agri Business• Policy -Hedge 100% of sales

• Directors

• GM Finance

• Head trader

• CFO



Agri Business• Policy -Hedge 100% of sales

• Directors

• GM Finance

• Head trader

• CFO



Bank• Policy –VAR not greater than

$X million

• Directors

• GM Finance

• Head trader

• CFO



Bank• Policy –VAR not greater than

$X million

• Directors

• GM Finance

• Head trader

• CFO



Gold Company • Policy -Hedge X% of projected

production

• Directors

• GM Finance

• Head trader

• CFO



Gold Company • Policy -Hedge X% of projected

production

• Directors

• GM Finance

• Head trader

• CFO

• Mine Manager



Power Company• Policy -Hedge not less than

100% of committed sales

• Directors

• GM Finance

• Head trader

• CFO



Power Company• Policy -Hedge not less than

100% of committed sales

• Directors

• GM Finance

• Head trader

• CFO

• Salesman/weather


“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:


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


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?


Event

EffectCause

The industry is moving to a common language for operational risk


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


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


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


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


Establishing a risk control frameworkEstablishing a risk control framework

• Organisation

• Policy

• Risk Indicators


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.


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:


• 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


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)


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


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


. . . Only if someone follows-up

“What gets measured gets done . . .”

Risk Indicators


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


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.


Reporting No FX Risk ?Reporting No FX Risk ?

Base Gap

-150

-100

-50

0

50

100

150

Sales

Purchases

Spot


Reporting No FX Risk ?Reporting No FX Risk ?

Pessimistic Gap

-150

-100

-50

0

50

100

Sales

Purchases

Spot


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


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


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


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


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


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


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


Economy & Finance

FX Risk Management – Best Practice Standards for Good Corporate Governance