| Treasurers must weather risk |
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Companies should rigorously analyse and hedge risk and look to new types of
non-financial derivatives, the annual conference of the Irish Association of Corporate Treasurers was told |
‘You only have one experiment - you only have one business’, warned Dr Ronan O’Connor in October as he recommended that all businesses develop simulation models to prepare for unknown risk. According to O’Connor, ‘if it can happen, it will; all you have to do is wait’. He was speaking at the twelfth annual conference of the Irish Association of Corporate Treasurers (IACT) where ‘The New Treasury Environment’ was being discussed by Ireland’s leading practitioners. Described by George Lee, conference moderator, as ‘poacher turned gamekeeper’, O’Connor lectures in Risk Management and Actuarial Science at University College Dublin. He has spent much of his career at the coal face of financial services in companies like Citibank, Ulster Bank and Gandon.
‘Companies which get into difficulties do so for the same reasons every time’, he said, advising his audience that ‘everything that you cannot afford to lose’ should be insured. Optional cover should depend on the cost of insurance, he said.
A risk management strategy can be based on a ‘strategic triangle’, according to O’Connor, where the three points of the triangle are ‘Solvency, Expansion and Shareholder Return’. Depending on the nature or stage of development of a company, all risk management strategies could be adapted from this triangle. Solvency could be fixed and expansion could be developed. Alternatively, shareholder return could be targeted and the relationship between solvency and expansion could be examined.
A third strategy would be to concentrate on expansion and the identification of what is needed to attain solvency and expansion. Mentioning the basic rule of ‘never betting the ranch’, O’Connor outlined a step by step procedure for the management of risk. Firstly, a risk audit should be carried out on a company’s balance sheet and cash flow, identifying risk areas by highlighting potential variance in cash flows.
Next, a sensitivity analysis should quantify risk, and an agreement on the maximum allowable risk will establish a risk strategy. Once this model has been established, O’Connor suggested ‘dynamic programming’ where the model can constantly be improved to address current conditions. This should be followed by a search for internal offsets. Only the residual risk left at the end of this process should be re-insured, said O’Connor.
Addressing corporate treasurers, the university lecturer said ‘you’re not competent to handle’foreign exchange risk. He advised that all FX trading should be done to eliminate risk.
Merrill Lynch bankers, Ray Doherty and Charles-Antoine Janssen presented a paper on ‘Hedging Business Risk to Fix Operating Margins’.
Doherty and Janssen discussed hedging in areas such as petrochemicals and weather. The petrochemicals example they used involved a PVC producer fixing the margin between ethylene (35 per cent of the PVC manufacturing cost) and PVC. This would be attractive because the prices of ethylene and PVC have both been falling in recent years, but with no real correlation between their reductions, making ‘squeezes’ possible and hedging attractive. A typical structure they outlined is set out in the diagram above.
The Merrill Lynch team said it was estimated that 20 per cent of US GDP is linked to weather. In the US, national contracts of weather derivatives have grown from US$500 million in 1997 to over US$2 billion today. According to Doherty and Janssen, such derivatives are primarily used to transfer risk by organisations like oil and electric utilities, retail operations, breweries and amusement park operators.
The bankers predicted that within two to three years, weather derivatives would be as familiar to their audience as interest rate or foreign exchange risk. Eventually, they said, the market could move on to a position where smaller consumers could be involved in weather hedging, and even deposit accounts could be linked to the weather.
Treasurers should focus on ‘new’ corporate risks, according to Merrill Lynch. The new financial instruments to allow the hedging of previously unidentified risks are currently available - it’s just a matter of looking at the bigger picture. |
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| Article appeared in the November 1999 issue.
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