Management - art and science
Strategies for identifying and measuring risk can help treasury
personnel develop a sound diversification policy Before a risk profile can be managed it must be identified. What is considered high risk by one entity may be considered the normal course of business by another entity.
Appetite for risk-taking will vary not only between industries but also between management styles.Once risk parameters have been identified a measurement system must be introduced."A man who travels a lot was concerned about the possibility of a bomb on board his plane. He determined the probability of this, found it to be low, but not low enough for him; so now, he always travels with a bomb in his suitcase.
He reasons that the probability of two bombs being on board would be infinitesimal."The man has taken a strategic approach to risk management: He has identified the risk(s), their nature, location and probability.Likewise, a business or financial institution must balance its risk profile between financial risk and business risk. Senior management must decide how much business risk it can absorb and how much
financial risk is appropriate. Senior management also has the
responsibility of selecting the best mix between financial risk and
Business risk can be defined as risk arising from uncertainty about
outlays and operating cash flows, without regard to how investments
are financed. Financial risk is inherent in the movement of interest
and foreign-exchange rates. It also includes the risk of liquidity or
the inability to refinance debt.
Corporations will always absorb some incidental exposure. It occurs in
the light of competitive pressure. An example would be sales contracts
denominated in, say, exotic currencies, which are difficult to hedge
and often fluctuate wildly. Another more dynamic situation is the
challenge of designing a pricing structure to shift some risk from the
For example, the price of electricity could be linked to the
movement of the price of tin for a tin-producing entity. Thus, if the
price of tin decreased in the marketplace, the energy supplier would
lower the price of electricity to assist the tin producer in times of
reduced revenue streams. During the cycle, when the price of tin is
firm and/or rising, the cost of the electricity will increase
Reducing incidental exposure will increase the predictability of
results. From an analyst's perspective, reduced exposure is likely to
enhance value for the company, which will be reflected in its share
price. In the absence of a market view or a trend pattern developing,
management should hedge against incidental exposure.
Mismanagement of incidental exposure can lead to an escalation of risk
which eventually will impact on the core business exposure. Core
business exposures are those that will directly impact on the
business, are well known to the shareholders and often commented upon
An airline company, for example would have the price of oil per barrel
as core exposure. Management, investors and analysts alike would all
be aware what impact an increase of US$2.00 per barrel would have on
the cash flow projections of the airline company, should the company
A further illustration would be the impact of volatile interest rates
on the cash flows of a highly geared/leveraged company. If the company
did not have fixed rate funding, rising interest rates could have a
devastating impact on its expense base.Changing the core business exposures may lead to results difficult for investors to predict. This in turn may lead to investors liquidating their holdings or potential investors holding back.
For the company to simply hedge these exposures may not be appropriate. Untimely hedging is likely to result in the creation of a competitive advantage to the competitor(s) and a loss of profit for the company.
With regard to core exposure on-going analysis and management is
required to determine the optimal result.
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