Chapter 1 The Importance of Financial Risk Management – Essentials of Financial Risk Management

CHAPTER 1

The Importance of Financial Risk Management

What Is Financial Risk Management?

Financial risk management is managing the financial variables that affect the firm. It is an ongoing and continual process of identifying financial risks, assessing their potential for harm or opportunity, making a decision of the best managing technique, implementing the chosen risk management strategy, assessing the effectiveness of the strategy, creating a communication network and an associated level of transparency about the risks, and developing impactful risk management reports.

Financial risk management incorporates a set of tools, metrics, and best practices that have been developed over time. Although financial risk management is well developed as a practice, it remains in practice as much of an art as it is a science due to the nature of risk itself.

Financial risk management is a key component of successfully managing a company that has financial exposures, which includes almost any profit-oriented company. Financial risk management is not just a “nice to have” activity, but instead should be considered a necessity. In fact, it is increasingly becoming an expectation of all publicly traded companies. Additionally, it is imperative for senior managers and directors of these companies to familiarize themselves with the tools, techniques, and tactics of financial risk management. Knowledge of financial risk management and an understanding of the role it plays in the competitive success of a company are imperative for good corporate management and governance.

It is important to note that risk is two-sided; it can be either positive or negative. The definition of risk that we use is that “risk is the possibility that bad or good things may happen.” This of course is slightly different from the lay definition of risk. However, financial variables can move in favor of the organization; a key supply commodity can fall in price, interest rates can fall and decrease interest costs and increase demand for a firm’s products, or currency rates may change so as to make a company’s products more price competitive in other countries.

There are three elements to our working definition of risk: (1) risk is about the future, (2) risk has an element of uncertainty, and (3) risk has an upside and a downside to it. Thus, financial risk management is a forward-looking activity that one needs to be aware of and must be flexible enough to deal with uncertainty, and financial risk management needs to manage both good risk and bad risk. It is the last element that often gets neglected in risk management. All too frequently, risk management is focusing on managing the downside risk, while not seeing, and thus not taking or capturing, sometimes even more significant upside risks. Effective financial risk management applies to managing both bad risk and good risk.

Why Is Financial Risk Management Important?

In the last two decades, a wide variety of advanced-level university programs in financial risk management, risk engineering, or risk mathematics have been developed. Additionally, various organizations and certification programs devoted to the field have become popular among practitioners and those wishing to enter this dynamic profession. Most corporations, particularly those with international scope, have organized a dedicated financial risk management department, often including a C-level executive. Of course, this has always been the case for financial institutions, whose reason for being is to manage financial risk, but the prominence of financial risk has also become of almost equal importance in nonfinancial corporations.

There are a wide variety of reasons as to why financial risk management has become so prominent. One of the primary reasons is the globalization of the economy. The rapidity of the rise of globalization has not only increased the level of competitiveness, but also dramatically increased the connectedness of economies. Globalization means that it is no longer sufficient to be the best managed company within your specific home piece of geography, selling products and services to a dedicated and loyal client base. Today’s customer is global, and so is today’s competition. As such, global economic factors and financial markets have the potential to tip the playing scale to one’s advantage or disadvantage. Labor rates, exchange rates, different tax regimes, and differing access to and cost of raw supplies can gain one a competitive advantage or put one at a significant competitive disadvantage. Without the ability to manage these factors, an organization is leaving itself at the whims of the economic Gods and, more importantly, in the crosshairs of their competition who do gain the ability to manage these financial risks.

Also related to globalization is the connectedness of markets. What were once isolated risks, confined to either one specific sector of the market, or one part of the global economy are now events that tend to become globally systemic. This, of course, was most clearly seen during the 2008 financial crisis when basically all major markets globally suffered massive losses in unison. In a global environment, where potentially no one is safe, the need for risk management is key for long-term survival and competitive advantage.

The connectedness of the markets leads to the concept of emergence, which is a fundamental property of what is known as complex adaptive systems. Emergence is a phenomenon that is observed not only in a wide variety of biological systems, but also in economic systems. Emergence explains how fads and feedback loops get started, as well as stopped. Many economists use emergence as an explanation for stock market bubbles and crashes, for the volatility of commodity prices, and for changes in consumer demand for goods and services. A fundamental property of complex adaptive systems is that we can observe trends and patterns after the fact, but are hopeless in our ability to predict them. We will have more to say about complex adaptive systems later in this chapter, but for the moment it is important that the increasing complexity of the global economy increases both the need for and the value of proactive financial risk management.

Awareness of risk management techniques has developed its own kind of feedback loop leading to increased adoption. The rise of financial products for trading financial risks starting in the late 1970s with the emerging markets for future and option contracts led to the development of bespoke over-the-counter products for virtually every financial risk imaginable in the 1990s. That development has continued to the present-day scenario where financial engineering as well as the emerging “fintech” technologies have made the ability to manage financial risk ever more sophisticated, yet ever more accessible to even the leanest of companies. With this increased accessibility to financial risk management products and techniques has come an increased expectation that companies will make use of financial risk management know-how.

Stakeholders expect companies to have a view on financial risk management and to implement that view with the appropriate financial risk management tactics and products—even if that view is that financial risk should not be managed by the company, but by the stakeholders themselves. Stakeholders in an organization are increasingly demanding that the firm develop and communicate a clear risk management philosophy and for them to consistently implement risk management tactics that are consistent with that philosophy. This is a point that we will discuss at length in Chapter 10 when we discuss risk management governance.

Increasingly, corporate stakeholders do not like to be surprised by corporate results that are affected by financial risks that could have been hedged away; with the possible exception of a few select type of companies that explicitly and consciously desire to have their corporate valuation subject to the whims of the financial markets or commodity prices. Share price volatility causes lower share valuations and higher debt financing costs (ironically, a result that is a function of advances in quantifying and managing credit risk). Credit agencies in particular have developed financial models that illustrate how credit ratings, and the associated probability of default, are based on financial share price volatility. Banks routinely make the financial risk management practices of corporations a major part of the credit analysis process, and frequently incorporate specific financial risk management practices as one of the covenants before granting a loan.

Regulators are another group of stakeholders who closely monitor the financial risk management practices of a company. Many industries voluntarily and preemptively implement best practices of financial risk management to avoid having more rigorous risk management imposed on them by regulators. Regulators frequently rely on financial risk management metrics as a way of assessing the viability and the compliance of the firm. This has led to compliance being an integral part of the financial risk management agenda.

Customers and suppliers do not like surprises caused by a lack of appropriate financial risk management practices. Fluctuating prices and shortages of supply can destroy whatever goodwill that a company develops with its customers. Conversely, creatively using financial risk management techniques can provide a competitive advantage in both attracting new customers and keeping existing customers.

Case Study

Irving Oil

Irving Oil is an integrated energy company headquartered in Saint John, New Brunswick, which through its subsidiary Irving Energy, provides customers, both industrial and retail consumers, a “Price Cap program” which it describes as follows:

With Irving Energy, you can cap your home heating rate for 12 months! With Cap Pricing, you pay a small fee to ensure that your price will never go higher than the capped price. But should prices go down, you get the benefit of paying the lower price.

This is analogous to buying a call option: you pay a premium and are protected if market prices rise, but retain the benefits if prices fall! This type of contract provides access to hedging options for many companies without the sophistication or desire to trade financial products on their own. The customer now knows that regardless of how high market prices go over the next year, they will never have to pay more than the agreed-to price cap. This increases their budgeting and forecasting abilities, increasing the probability of meeting financial objectives. The 12-month term offered by Irving is quite standard, and does not provide any protection from rising market prices beyond the following year.

An often neglected stakeholder group that might be one of the most impacted by inappropriate financial risk management is the employees, and by extension the future employees, of the organization. There is the obvious impact of the company going bankrupt. Other major concerns exist though beyond the existence of the company and its related job security. Many employees have share ownership programs. Excessive levels of stock price volatility impact them directly in the value of their personal portfolios. Perhaps, the biggest impact is value volatility of pension programs. As the baby boomers begin to retire, underfunded, or excessive volatility in pension plans will become more exposed and make companies more vulnerable in the war to attract talent.

An industry of training for risk management expertise has developed to supply managers the expected expertise. What was once considered to be esoteric and solely for the specialist is now common place. For instance, back in the early 1990s, swaps were considered a novel and hard-to-understand product. They were new, novel, and cutting edge. Now swaps are covered in virtually every undergraduate business program as part of the core curriculum, and are considered as mundane a product of risk management as a calculator might be. During the 2008 financial crisis, products such as credit derivatives and highly structured collateralized debt obligations, more commonly known as CDOs, were likewise considered esoteric, but it is likely that their use will someday be seen as common. Today, we have fintech products such as blockchain and cryptocurrencies that are new and novel. These tools are already changing the financial risk management landscape in profound ways and new developments will continue to emerge.

It is not just knowledge of the risk management products themselves that is important. It is also an increasing awareness of the tools, tactics, and measures of risk management. Everyone, from Board members to the newly hired employee, is expected to be familiar with a range of financial risk management topics. Awareness has created an expectation. It has also created a demand for risk management educational opportunities, as well as professional certifications. Two of the major risk certification programs are the Professional Risk Manager designation, offered by the Professional Risk Manager’s International Association (PRMIA), and the Financial Risk Manager designation granted by the Global Association of Risk Professionals. To meet the demand, Universities are creating specialized degree programs in financial risk management and financial engineering.

Ultimately, the major stakeholders in financial risk management are the managers themselves. Higher volatility of stock prices, particularly when caused by hedgable risks, is seen as a sign of ineffective management, and thus careers and career progression are at stake for managers whose financial risk management skills are not competitive. Even mid-level managers need to be aware of how financial risks can affect the achievement of their operational goals, and failure to understand the risks and to manage them is considered inexcusable and potentially career limiting.

Strategic Importance of Financial Risk Management

A common misperception is that financial risk management is simply about controlling the volatility of costs, prices, and credit risk. Financial risk management ultimately has its biggest virtue in being a major element of implementing the strategic plan. The hedging strategy of the firm has a direct role to play in not only setting, but also implementing a strategic plan for competitive advantage. How an airline chooses to hedge its fuel costs also helps to determine the pricing strategy relative to its competitors. The pricing plans a company offers its customers, based on its own financial risk management, can become a comparative advantage in the eyes of its customers. Mining companies can decide whether their value is based on their effectiveness of mining commodities, or based on the value of the commodities they mine on the basis of their financial risk management strategy.

Thus, for many companies, financial risk management has relatively little to do with the direct financial results and a lot more to do with implementation of the strategic plan. In those companies, financial management is truly value-added and a source of competitive advantage. An effective financial risk management strategy allows for a much wider set of alternatives for the strategic vision of the firm. Financial risk management becomes a catalyst and an enabler for strategic management.

Types of Financial Risk

There are six major types of financial risk, and a few specialty classifications as well. Although there are similarities in how each of these types of financial risk is managed, there are also specific differences between them. There are different measures for risk in each of the markets, as well as specific market dynamics that need to be accounted for in how the financial risk management products work in each of the markets.

Perhaps the most prominent financial risk is interest rate risk. It is the risk that arises through changing interest rates. Interest rate risk affects not only financing costs, but also potentially affects demand for a firm’s products or services. Of course, interest rates also affect the overall economy, which affects all companies. Consider for a moment the effect of interest rates on the demand for housing, automobiles, and other high-ticket consumer items. However, effective financial risk management can mitigate the negative effects of interest rate changes and likewise help the firm leverage advantageous changes in interest rates.

The second most prominent financial risk for managers to be concerned about is currency risk which arises through changes in exchange rates between countries. Currency risk is closely related to interest rate risk as it is directly tied to the relative interest rates between countries. It is a common misperception that currency risk is only an issue for organizations that have international operations or sell their products internationally. However, in the global economy, all companies are affected by currency risk as it changes the relative competitiveness of foreign competitors and foreign substitutes. If the domestic currency strengthens relative to the currency of a competitor, then the domestic competitor will be at a relative price disadvantage solely due to the changes in exchange rates. Of course, exchange rates will also affect the price of commodities and perhaps even the price of substitutes. Exchange rates can also ripple through an economy, significantly impacting trade balances and overall economic growth. Thus, currency risk can be a company-specific risk, an industry-specific risk, or even a country-wide systemic risk.

Volatile energy prices are a constant concern as well. Energy risk management in particular has some specific risk management issues. Energy is a commodity that cannot be transferred digitally, unlike an interest rate or a currency. Energy is also a local product, and thus the price and availability of electricity in Texas can differ quite substantially from the price in New York, for instance, if a storm has knocked out the transmission capabilities in the area.

Credit risk can arise in many different forms. It is most often associated with the risk of a specific company having a credit event such as bankruptcy. However, credit risk can also be systemic as was observed during the financial crisis when credit availability was extremely difficult to find regardless of the financial health of a firm. Companies that did not manage their credit risk adequately found themselves scrambling to source even short-term credit. Even highly rated General Electric was rumored to be facing a significant credit crunch during the worst moments of the crisis.

Commodity risk is the risk that the price of commodity inputs, or the sale price of commodities will change. Commodity prices can be affected by a wide variety of factors and can be particularly volatile. Commodity risk is probably the financial risk that has been managed for the longest period of time. It was mentioned earlier that there were indications that derivatives were used to hedge agricultural products during biblical times. Markets for the trading of commodities are the oldest of the exchanges.

There are a few other risks that, while strictly speaking are not financial risks, are sometimes included with financial risks as related products and tactics for managing them exist. Two such products are weather risk and catastrophe risk. Weather risk is the risk involved with changes in weather patterns and catastrophe risk is associated with major events such as tornados or floods.

Ultimately, all financial risks become strategic in nature. Effective management of these financial risks can lead directly to long-term strategic advantage. Of course, the converse is also true in that ineffective management of financial risks can lead to a strategic disadvantage.

Financial Risk Management Tenets

Throughout this book, we will rely on a few central tenets that will guide the discussion. These tenets form a solid basis for understanding the potential role that financial risk management can play in an organization’s success.

Firms Are Not in Business to Take Financial Risk

With the obvious exception of financial institutions, and some commodity trading and mining firms, corporations are generally not in business to take financial risk. They are in business to create and market products and services. That is their competitive advantage, and that is what they should stick to. If they believe that their expertise is in predicting financial prices, then they should become a hedge fund or a trading firm. Implicitly we know of many firms that act like a hedge fund. They confuse prudent financial risk management with activities that are more in line with financial trading. It almost always ends poorly.

This is not to say that nonfinancial firms should never take a view on the markets and adjust their risk management techniques accordingly. However, if more focus is put on forecasting financial prices than making and marketing products, then there is a serious strategic risk management issue within the company.

Ironically, firms often unintentionally slip into actively taking financial price risk through the hedging they do for their financial risk management program. The risk management activities make a profit, which of course in a proper hedging program means that the firm had an associated and offsetting loss in its operations due to the move in financial prices. Some firms, however, fail to commingle the gain from their hedging program with the changes in the cash flows from their operations. They jump to the incorrect conclusion that if they made profits from doing a little bit of hedging that they should thus do more hedging. They proceed to expand their hedging program without an offsetting increase in the size of their operations. This means that the size of their hedging activities is out of balance with the size of the financial risk associated with their operations. This imbalance is essentially taking a speculative view on the financial markets. It is something that we strongly caution against. In large part, this is what sparked many of the corporate derivatives debacles. It is a case of using a very valuable tool much too aggressively and in a way that it is not intended.

Firms are in business to provide a product or a service. They are not in business to take financial risk.

Ignoring or Being Unaware of a Financial Risk Is Still a Risk Management Decision

Ignoring or being unaware of a financial risk is still a risk management decision. It is simply not a good financial decision. Many companies claim that they do not believe in hedging financial risks because they consider it too difficult to do so. We believe that this is a preposterous decision and a shameful decision as well.

A risk management program does not need to be sophisticated. Likewise, developing a basic knowledge of the financial risks that a firm is exposed to is not difficult. Indeed, it is true that some companies do build elaborate risk management models and implement incredibly advanced plans for financial risk management. However, much value can be gained from just the simplest of risk management tools.

We will argue that, like with any other organizational tactic, financial risk management practices can be taken too far. Choosing the appropriate level of financial risk management for an organization, however, is not hard to do. The common sense and intuition of the Board and the senior management team should be able to make a decision on this.

There is simply no adequate excuse or reason for a firm to choose to ignore or be unaware of financial risk and financial risk management practice. The only time that an organization should ignore a financial risk is when they have extensively analyzed it and come to the conclusion that the risk is not sufficient to warrant the effort to manage it, which in some cases is the prudent and proper decision.

Hope Is Not a Prudent Financial Risk Management Strategy

Related to deciding to remain ignorant of financial risks is the strategy of hoping that financial risks will go in your favor. It sounds silly, but “hoping” is the strategy implicitly adopted by many firms. With the availability and ease of use of tools for prudent financial risk management, it is almost unethical and certainly irresponsible for managers to rely upon hope as the basis of their risk management. Hope is obviously not a prudent financial risk management strategy.

Financial Risk Management Is as Much an Art as It Is a Science

The advent of educational programs and certifications for financial risk management has made it seem as if financial risk management was some type of science on a par with physics or mathematics. In fact, many of the participants in these financial risk management programs come from a background of mathematics or physics (and in the interests of full disclosure, so do one of the authors of this book).

Risk management is based on uncertainty and probability.1 This implies that we are ignorant about the specifics of what will happen in the future. Mathematics, however, is based on axioms that are always true and predictable (one plus two will always be equal to three) and physics is based on the laws of nature (an apple will always fall to the ground when dropped on earth and will not randomly float upward). So although we are constantly trying to make risk management seem more like science, there is a limit to how far we can go with this. Risk has a fundamentally different character than science.

In our experience in risk management, we have seen a growing separation between what we call the “gray hairs” and the “mathematicians.” The “gray hairs” have significant experience and intuitively understand how the financial markets work. The mathematicians know advanced analytical techniques and can quantify probabilities of outcomes of risk management strategies. Both have something to offer in developing risk management ideas. Ignoring the mathematical ideas of risk management means that one will miss out on a lot of powerful tools and ideas. However, it is equally true that ignoring the intuition of risk managers who have experience in how the markets work means also ignoring very valuable insights and ideas.

Great risk management involves both the art and science of the discipline. Ignoring one at the expense of the other will always lead to suboptimal results, and perhaps even financial disaster.

The Only Perfect Hedge Is in a Japanese Garden

As just stated above, risk management is about the future and uncertainty. It is simply not possible to have perfection when one makes plans for the uncertain future, and thus risk management is as much an art as it is a science. Furthermore, even with the benefit of hindsight, which of course is not possible, risk management tradeoffs and compromises will need to be made. There is no perfect plan, and there is no risk management plan that does not involve compromises. There is no perfection in financial risk management. An old adage of risk management that we certainly buy into is that the only perfect hedge is in a Japanese Garden. The flip side of this is the equivalently true adage that it is better to be approximately right than be precisely wrong.

Risk Management Is Complex

Earlier in this chapter, we discussed complex adaptive systems and its central property of emergence. Complex systems and emergence come about when agents (for example, starlings in the sky, fish in the ocean, or people in an economy), can interact and also when they can change their behavior. Thus, we get murmurations of starlings, schools of fish, and stock markets bubbles and busts—all of which are examples of emergence, and all of which demonstrate that we live in a complex world.

Complex systems are contrasted with complicated systems. Complicated systems run by the axioms of mathematics, and the laws of science. They are completely predictable and they are also completely reproducible. We can fire a missile with incredible accuracy. We can plot the orbit of the planets in minute detail for decades to come. We cannot, however, predict what financial prices will be next week, much less next month. That is the difference between complex systems and complicated systems. We can see patterns in complex systems, but only with hindsight. We have no ability to forecast complex systems.

Management of complicated and complex systems requires very different skill sets. In part, this comes back to the art and science of risk management. In part, it is the reason why there are no perfect risk management solutions. As big data, and artificial intelligence, and as more people get trained and certified as risk management “scientists,” it is important to remember the difference between a system that is complex and something that is complicated.2 Risk management is complex.

Financial Risk Management Adds Value

Despite the lack of perfection, a properly designed and implemented financial risk management plan does add value to the organization. Although most risk management strategies come with a cost, which may be an explicit cost and/or an implicit cost, the benefits of risk management almost always outweigh these costs in the long run.

One of the direct benefits is that financial risk management lowers financing costs. Financial risk management also leads to lower stock price volatility, which in turn leads to higher valuations. However, there are also many indirect benefits of financial risk management. It leads to more stable costs, which in turn allows the firm to offer more stable prices. Financial risk management allows managers of the firm to concentrate on the operational tasks that they can affect, rather than what is happening in the global financial markets which they cannot affect. This leads to better management performance, which in turn leads to better organizational performance. Ultimately, prudent financial risk management leads to peace of mind.

Financial risk management is a value-added tool that should be exercised by virtually firms in some way, shape, or form.

Concluding Thoughts

Financial risk management is not a “nice to have” activity, a luxury for large corporations, or something that can be ignored by a company without explicit interest rate, currency, or commodity risk. Financial risk management is imperative for every organization that has financial stakeholders.

While financial risk management does involve some advanced tools, techniques, and admittedly some advanced mathematics, the reality is that the basics of financial risk management can and should be understood and practiced by all managers and directors. It is an activity of the firm that adds significant value and greatly improves the achievement of the strategic objective of the firm.

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1You may believe that using the terms probability and uncertainty in the same sentence is redundant. In the theoretical risk world, the two have quite different meanings. Probability implies that we have a mathematical formula to calculate the odds that something will happen and that we know the range of outcomes. For instance, if I flip a fair coin, then I know there is a 50-percent probability that it will land heads up and a 50-percent probability that it will land tails up. Uncertainty implies that you do not know the range of outcomes possible. For instance, I cannot predict what the most popular consumer product will be 50 years from now because it is not possible to forecast the range of new products that will be developed in that time period.

2For the reader interested in learning more about the role of complexity in business, a suggestion is R. Nason. 2017. It’s Not Complicated: The Art and Science of Complexity in Business (Toronto, Canada: University of Toronto Press).