HomeAnalysisManaging financial risks in a dynamic environment

Managing financial risks in a dynamic environment

The term “black swan” in finance relates to high impact and least expected events. The origins of this term in financial risk management are associated with Nassim Nicholas Taleb through his book The Black Swan.

Nassim defines the risk management problem as “the confusion of absence of evidence of black swans (or something else) for evidence of absence of black swans (or something else)”. Thus the emergence of financial “black swans” tends to be associated with lack of preparedness regarding dealing with risks.

Well-known “black swans” include the fall of Enron in 2001 and Lehman Brothers in 2008. In the 12 months before its fall, Lehman had boasted that it was prepared for liquidity risk. In Zimbabwe, the fall of Trust Bank, AfrAsia Kingdom Bank and Interfin Bank, long seen as the symbols of black success in the country, are “black swans”.

At global level, the financial crisis of 2008 is one of the biggest “black swans” in recent history. Very few people expected that the collateral debt obligations (CDOs), for long certified AAA and though anchored on sub-prime loans, would fail Wall Street and eventually the global financial system in that fashion. Neither did anyone imagine that any advanced economy would default on an IMF debt as did Greece when it became the first to do so in 2015. “Back swans” tend to come as a surprise and are of high impact.

The events above redefined the global governance and financial system. Out of them was born the Sarbanes Oxley Act and the Dodd Frank Act. Both acts, while dealing with the problems at hand, have been seen to be excessive. The Donal Trump administration is trying to revamp the Dodd Frank Act in order to release reserves for banks to lend more. It can be noted that while one risk is being managed, another may be created unintentionally.

It is not easy for a treasurer to predict the market shocks given that they are rare. Neither can a treasurer be fully prepared for such events. Their level of preparedness may come in the form of contingency plans which could enable the company to continue in business even after major disruptions. While there are many ways of managing risk, I will cover those considered as sophisticated — the derivatives. The existence of a derivative demonstrates the presence of an underlying asset or transaction; this is normally referred to as the “underlying”. This article will demystify the derivatives using simple language so that any finance manager or treasurer can easily implement them with ease.

A treasurer can use fixing instruments or outrights. Fixing instruments are very simple to implement while at the same time they are less expensive. There is no cash outlay required at inception. What is only required is for two parties to agree to exchange the “underlying” at a certain date in the future. Given that fixing instruments are binding on both parties, it entails that they create what is called an opportunity risk. This arises as a result of failure to have the ability to take advantage of favourable movements in the market once parties have committed to a deal. Fixing instruments are available even in the most basic of markets.

Outright instruments do fix the hedged outcome of an entity. This means that an entity will decide the price or rate at which it can make an acceptable margin and then lock itself into that rate by purchasing fixing instruments. What the company would have done is to achieve certainty regarding its profit margins. However, it cannot take advantage of favourable movements in the market since it has committed itself. With such instruments, both the buyer and the seller are obliged to transact at an agreed rate at an agreed future date.

Access to fixing instruments can be via an exchange or over the (bank’s) counter. The focus here is on over-the-counter (OTC) instruments. With OTC instruments, the treasurer will deal directly with the counterparty. The contract is made to specification. This means that the amount and the terms are negotiated and agreed by the buyer and the seller. There is no standardisation.

In addition, the trading hours are unlimited. What is important is the availability of the parties to the transaction. However, they do create counterparty risk; the risk that the counterparty will fail to perform their side of the agreement when the other party has performed their respective part.

A common form of fixing instruments is a forward contract, which is an agreement to buy or sell a known amount of a traded asset at a future date. There is always a buyer and a seller to a forward contract. While there is no cash cost at establishment, the parties are obliged to transact at the future date as they would have agreed even though with hindsight it would appear unreasonable.

Settlement of a forward happens at maturity or expiry of the contract. It is at this time that the underlying may be delivered. There are some forward contracts which do not result in the delivery of the underlying. These are called non-deliverable forwards. Instead of delivery of the “underlying”, they are instead cash settled. The common is for the ‘underlying’ to be delivered.

In the case of a foreign currency forward contract, delivery of the underlying may be expected in the case where the treasurer would want to use the bought currency to settle a known obligation. The treasurer would have entered into this contract as he expected the bought currency to strengthen.

When it comes to interest rates risk management, the treasurer can use forward rate agreements (FRAs). Two parties enter into an agreement to lock the interest rate to be paid at a future date. In finance this is one of those derivatives known as contract for differences in that the principal amounts are not exchanged at all, rather the notional amounts upon which interest rate computation is based are known. A borrower can borrow from Mufaro Bank and buy an FRA from Zanorashe Bank. Thus the FRA does not have to be bought from the same counterparty who lent the money to the borrower.

To contextualise this, let’s suppose that two parties agree to enter into an FRA in two months’ time for a period of three months (2v5). The interest is agreed today for a transaction that will begin in two months’ time. Thus settlement for a rate that will run for three months at the end of the two months starting from today will happen at the start of the interest rate period. A borrower buys an FRA to insulate themselves from interest rate rises.

Thus at the settlement date if the market rate is higher than the FRA rate, the seller of the FRA will indemnify the buyer. However, as the settlement is happening at the beginning of the interest rate period, the settlement should take into account the essence of the time value of money by discounting the future cashflows at the agreed upon market interest rate.

In managing risk, besides fixing instruments, the treasurer can use options. Options are contracts which give the holder or the buyer the right, but not the obligation, to buy or sell the “underlying”. There is always a cost to an option and it is normally known as a premium. Options differ from fixing instruments in that there is a party who is obliged to perform their side of the contract and in this case it is the seller. The seller is also known as the writer. The buyer is seeking protection. He can get it at a premium. The premium gives him the right to choose to exercise or to decide whether to go ahead or not. Many companies specifically prohibit their treasurers from writing options as writing tends to expose a party to unlimited losses.

Following a number of corporate scandals involving derivatives, including the Barings Bank debacle, some began viewing derivatives (and options in particular) with scepticism. Options are characterised by a strike price, which is the price at which the holder of an option may “exercise” the option or buy or sell the underlying.

The decision to “strike” is linked to whether the strike price is favourable to the spot price. When the strike price is favourable compared to the price of the underlying, then the option is said to be in the money. If the strike price is not favourable then the option is out of the money, while it is at the money if it is equal to the underlying price.

A call option gives the holder the right to buy the underlying at an agreed strike price while a put option gives the holder the right to sell the underlying at an exercise price at a given date. An American option can be exercised at any time before and on the maturity date whereas a European option can only be exercised at expiry of the option.

Many people get into options or similar arrangements without knowing. For instance, buying insurance is similar to buying a put option though not exactly. The major difference being that for one to buy an option there is no need for an “insurable event”. The holder of a put option has the right to sell the underlying at a predetermined price. Thus he is expecting the value of the underlying to decline.

This is the same with insurance. The buyer of insurance is seeking protection against the fall in the value of the asset they are enjoying or using. When the car is damaged in an accident, the buyer of insurance sells that car to the insurance company at the exercise price. In the event that the value of the underlying has not fallen at the end of the insurance period, then the holder of the insurance walks away after having parted only with the premium.

A call option on the other hand is suitable when the treasurer expects the value of the underlying to rise. What this means is that at the end of the term should the price of the ‘underlying’ rise above the strike price, then the holder will buy at a lower price and sell at the market or spot price which is higher, thereby locking a clean profit. In the event that the exercise price is unfavourable, the holder of the option walks away after having lost the premium only. After all, they can buy the “underlying” cheaper at the market price. Thus options give the holder some insulation while at the same time allowing the holder to take advantage of favourable market movements.

While the discussion above focussed on managing financial risks in a more sophisticated way, the objective is to maximise shareholder wealth. Companies which manage risk effectively tend to be more valuable than those which are weaker in managing risks. Companies should therefore pay particular attention to financial risk management by employing skilled and well trained professionals.

The main custodians of financial risk management are treasurers. A trading company or non-bank is not in the business of taking financial risks, otherwise they would rather be a bank. Yet such risks, if not managed, can result in the company becoming uncompetitive or being thrown into ruin, thus augmenting the need to manage these risks.

However, no matter how well-trained or qualified a treasurer is, it is difficult to anticipate “black swans”. The role of treasurers is growing in importance, especially as hedge accounting takes centre stage.

Ngwira is a chartered accountant, former bank treasurer and former university lecturer. He holds finance and business qualifications. — daniel.ngwira@gmail.com, +267 73 113 161.

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