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Is your financial risk management strategy up to date?

Is Your Financial Risk Management Strategy Up To Date?Summary:

  • Continuing breakdown in correlation between the price of the Australian dollar and commodity prices may present challenges to current hedge strategies
  • Basel III capital reform is likely to increase the price of hedging using the derivatives due to additional capital required for counterparty credit risk along with over-the-counter (OTC) reform changing the way derivatives are settled and cleared
  • The new IFRS 9 Hedge Accounting standard will provide opportunities for more favourable accounting treatment for some hedging strategies.

Financial risk management has always been a complex area for companies’ management given the volatility and significance of the risks involved. As such, financial risk management strategies should result in clear policy, including identification and measurement of the financial risks, and will naturally depend on the risk appetite of the company.

According to a recent Deloitte third quarter CFO Survey, CFOs were mainly concerned about global factors such as the slowdown in China and European sovereign debt issues, but also local issues such as uncertainty over federal government policy, commodity prices and the price of the Australian dollar. In addition, continuing capital reforms in the banking industry affecting the price of credit and the changing regulatory and accounting standards landscape, along with side effects such as a continuing weak correlation between the Australian dollar and commodity prices, present additional challenges to an already complex area of financial risk management.

Capital and Regulatory reform

Basel III impact on the price of derivatives

Under new Basel III rules (locally implemented in Australia from 1 January 2013), a new capital requirement is being introduced on derivatives – in other words, banks will be required to hold more capital to cover potential mark-to-market losses on the expected counterparty risk on OTC derivatives, commonly known as credit value adjustment, or CVA.

The Australian Prudential Regulation Authority (APRA) acknowledged that higher quality and quantity of bank capital liquidity comes at a cost. Increases are being seen already in derivative pricing, reflecting the higher capital requirements for uncollateralised OTC derivatives, with the most significant impact being on derivatives with longer maturities and higher credit requirements (such as cross-currency swaps). However, as discussion at the Finance & Treasury Association has suggested, there are multiple factors affecting the cost of bank products, including derivatives.

Some measures available to mitigate the increased costs in relation to CVA are Credit Support Annexes (i.e. agreements between counterparties to post collateral as a measure to decrease credit risk), which however brings along additional costs required to fund the collateral/margin call. Another way to mitigate counterparty credit risk is a netting arrangement (e.g. using International Swaps and Derivatives Association (ISDA) contracts). Both go hand in hand with the aim of the regulators to move OTC derivatives to a clearing regime.

It is possible that plain vanilla hedging strategies will not bring a significant increase in the costs of hedging compared to the liquidity risk and costs of posting collateral or the profit volatility associated with not hedging at all.

OTC reform

With the European Markets Infrastructure Regulation – EMIR ─ adopted in the European Union and the Dodd-Frank Act in the U.S., continuing reform of OTC derivative markets overseas may have some, albeit limited, cross-border impact on local non-financial companies, such as requirements around the prompt exchange of confirmations, where non-cleared derivatives must be confirmed, by electronic means where possible, and within strict timelines. Non-financial firms may consider requiring a margin call from banks to reduce their credit risk or, on the other hand, they may be willing to post collateral to obtain a more favourable derivative price.

On 30 October 2012, APRA, the Australian Securities and Investments Commission and the Reserve Bank of Australia released a Report on the Australian OTC Derivatives Market. This report reviews the risk management practices of market participants in the domestic OTC derivatives market and concludes that there are strong in-principle benefits for the domestic OTC derivatives market to use a central clearing platform. The regulators recognised that the suitability of using central clearing infrastructure will not be the same for all participants. The regulators’ view that for large and more active market participants, daily collateralisation of exposures should be adopted as best practice in the market, where possible, may suggest that the impact on non-financial companies will be limited (e.g. similar to end-user exemption under the Dodd-Frank Act in the U.S.). The report also pointed out scope for further improvements to operational and risk-management practices in relation to non-centrally cleared transactions.

Correlation of price of the Australian dollar (AUD) and commodity prices

The continuing strength of the Australian dollar (also due to relatively high local interest rates compared to the rest of the developed world and a relatively high and stable credit rating) with volatile commodity prices (which declined in 2011 to a significant extent without a correspondingly large decline in the AUD) somewhat distort the long-term relationship between the AUD rate and commodity prices.

This tension may have challenged existing hedging strategies and, if the breakdown in correlation continues, this will continue to do so. Treasurers and financial risk managers will need to monitor this area closely and assess the merits of alternative strategies less dependent on correlations.

Accounting change

Changes proposed in the IASB Exposure Draft on IFRS 9 General Hedge Accounting will enable better alignment of risk management and accounting approaches and we will explore them in more detail in the March issue of Charter.

For the structure of hedging strategies, the most significant opportunities are represented by changes to the accounting of the time value component of an option. This is expected to result in less profit or loss volatility and thus may prompt more frequent use of the options as a hedging instrument by Australian companies. Another change will allow an exposure that includes a derivative and non-derivative to be eligible for hedge accounting, enabling Australian debt issuers to improve the hedge accounting for their offshore funding in foreign currency swapped back to the Australian dollar. On the other hand, an increased price of cross-currency swaps due to counterparty credit risk may cause an increase of the relative price of offshore debt issuance compared to local funding, especially after taking into account other operational and compliance costs.

What does it all mean for the CFO or Treasurer?

Given their speed and significance, the recent developments may have an impact on the whole risk management framework. The following steps can help Treasurers assess if an appropriate control framework is in place and also assist the Board in determining the appropriate approach to managing financial risk.

Identification of the risk

Treasurers need to consider whether the volatile environment has changed the financial risks their company is facing, being either new financial risks arising (e.g. a breakdown of correlation between the AUD and commodity prices), or a change in the likelihood and/or impact of the financial risk (e.g. an elevated price of the AUD for a longer period of time). Also, external and internal changes may affect the risk profile/appetite of the company itself.

Measurement of the risk

The recent financial crisis tested limits of traditional forecasting and modelling, as many stress-tests did not take into account such adverse market events. Models used for measurement of the risk should not only accurately reflect current market conditions and inputs, but also should be able to perform scenario analysis, including a real worst-case hypothesis taking into account all possible correlations and stress scenarios.

Risk Management Strategy and Policies

The result of the identification and measurement of the risk should be assessing whether the current (hedging) strategies are the optimal choice based on the current and expected future environment (e.g. options may provide better economic results compared to forwards).

It is also important to know what the costs of the current hedging strategy are and whether it is the most efficient way to minimise the risk. For example, funding and hedging costs may decrease via issuance of the debt locally, given recent and expected movements of interest rates and increased costs of cross-currency swaps.

After all, a good policy to control the use of derivatives based on a bad strategy will not protect the organisation from its financial risks. On the contrary, an inappropriate strategy may have a detrimental impact on the business performance of the company.

Execution and Monitoring

Continuing change may increase operation and compliance costs of financial risk management and companies should re-assess whether the current operational model is responsive or whether alternatives, such as outsourcing of certain activities (e.g. hedge accounting), is a better option from a cost perspective.

The responsiveness and capabilities of the company’s information systems should be assessed. For example, a shift in the valuation approach on financial markets (collateralised vs. non-collateralised derivatives) will represent challenges to the existing Treasury systems.

Reporting and ongoing assessment

Boards need to review whether current Key Performance Indicators (KPIs) are appropriate, given the changes in the external environment and whether the reporting is sufficiently automated. They should also consider whether the KPIs provide sufficient information for their informed decisions in the required timeframe and frequency.

To work through these considerations and assess the impact may not be easy; however, answers to these questions will help to address challenges and make the most of the opportunities triggered by the current volatile environment.

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