| Building a robust risk management framework |
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By: Paul McEnroe, Paul McEnroe
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| Against a background of increasing volatility, corporates are becoming more sophisticated in the way they structure and manage their businesses, with even smaller corporates raising funds through the capital markets, writes Paul McEnroe, adding that it is therefore essential that corporates adopt a strategic approach to their financial risk management. |
It has been a difficult year for corporates operating in the interest rate markets. Market sentiment and movements have largely been driven by a central bank community that has been very data dependant, in a market where the data has been contradictory at best. The euro yield curve shifted significantly higher in the first half of 2006, as the central bank hawks came to the fore and the spectre of inflation once again reared its ugly head. Inflation fears were predominantly driven by higher oil prices and housing markets in the US and UK. In the last quarter of 2006, rates have abated somewhat and the yield curve has shifted lower, albeit flattening at the short end, following a series of rate hikes from the ECB.
This volatile background has caused problems for some corporates as they endeavour to control their cost of capital and maintain margins, in a market where they have seen significant input and transportation price increases over the course of the year. Corporates have had to become far more savvy and sophisticated in how they manage both their asset and liability portfolios. They have changed the way they source and manage capital and also how they view and manage the ensuing interest rate risk of both.
To raise capital, corporates have moved on from the traditional bank debt funding route and have increasingly accessed funds through the capital markets, which were once the sole purvey of only the very biggest plcs. Indeed, some mid-size Irish plcs and privately held companies have been active in 2006 in the capital markets.
Coupled with this increased sophistication in raising funds, has come an increased level of sophistication in the risk management of these funds, one that is far more forensic than before. Barclays Capital has worked with corporates to assist them in better quantifying and understanding their risks through a strategic risk management framework. The manifestation of this has been the increased use of more complex and appropriately tailored risk management products.
The approach aids management to evaluate and monitor risks on an on-going basis, so as to develop an efficient, yet flexible strategy, to maximize return within their chosen risk threshold.
The first consideration in formulating an effective risk management strategy is to have a clear objective for the ‘risks’ that the strategy is attempting to guard against. For example:
• Interest rate market risk should not impact my consolidated P/L by more than X million
• The weighted average of interest rates should not exceed Y per cent
In order to apply an appropriate and optimal risk mitigation solution, it is essential that the corporate has a clear understanding of these risks. Many corporates are now using risk management techniques traditionally applied by banks in managing their trading books. One such measure of risk is Value at Risk (VaR). VaR is a measure of how the market value of assets is likely to decrease over a certain time period (usually over 1 day or 10 days) under usual conditions, for a given confidence level e.g. 95 per cent confidence interval.
Key considerations in the estimation of VaR are:
• The model used to estimate the distribution (and the type of VaR)
• Confidence interval required
• Time horizon for analysis
In the context of examining interest rate risk exposure, the output of a VaR analysis should be a set of consistent stress tests (i.e. different portfolio realisations based on different interest rates. e.g. What would be the impact on P/L if interest rates double over the next 2 years?)
In this context, the advantage of a VaR analysis over simple stress tests is that:
• It provides a measure of a worst case scenario
• It provides a method to consistently model multiple sources of risk (e.g. if EURIBOR has doubled, what is a consistent move in the 10yr swap rate or in EURUSD?)
The output from the VaR analysis will then enable corporates to work with Barclays Capital to produce a risk management solution that best fits their portfolio requirements and reflects their risk appetite most appropriately. Any solution should take into account considerations such as the corporates taxation policy or accounting treatment.
Once the corporate has completed their risk analysis, it will be important to work with a bank that can deliver the right risk management structure given their unique requirements. While it is beyond the scope of this article to go into detail on specific structures, I have highlighted a number of structures that could form the basis for a bespoke solution, on some generic exposure types. I have also detailed the likely accounting treatment of some of these structures, though any such treatment would depend entirely on the individual company’s situation.
As corporates become more sophisticated in the way they structure and manage their businesses, it is essential that they adopt a strategic approach to their financial risk management. By building a robust risk management framework, they can better understand the risks they face and the impact of these on their bottom line, as markets move. It is only by doing this that they can apply an appropriate risk management solution for their unique criteria, thus enabling them to control their capital costs and ultimately maximise their return on capital. Barclays Capital has experience in working with a large number of companies, both globally and within the Irish market, assisting them in developing their own bespoke risk management strategies. |
Paul McEnroe is an associate director at Barclays Capital.
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