Chapter 16: Managing Risk in an Organization I think ‘risk manager’ is a misnomer. I don’t manage the risks—it’s up to the businesses to manage the risks. What we’re here to do is to provide assurance that risks are being monitored and managed. Kate Boothroyd Treasury and Risk Management, November 2004, p. 55 Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Important Concepts in Chapter 16 The differences between the practice of risk management by end users and by dealers Principles of effective risk management in an organization Accounting for derivatives How some organizations lost money using derivatives Responsibilities of senior management Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Structure of the Risk Management Industry End Users Firms that engage in derivatives transactions to manage their risk. Mostly non-financial corporations, but also pension funds, mutual funds, U.S. state and local governments, foreign governments, endowments, and other private organizations. In corporations the treasury department is usually responsible for derivatives transactions. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Structure of the Risk Management Industry (continued) Dealers Financial institutions that make a market in derivatives. They stand willing to take either side of a derivatives transaction. They typically hedge their risk and earn a profit off of the difference between their buying and selling prices. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Structure of the Risk Management Industry (continued) Other Participants in the Risk Management Industry consultants, including accounting, management consulting, and personnel search software firms law firms Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Organizing the Risk Management Function in a Company Good risk management requires a sound organization structure that begins with responsibility at the top. Dealers usually have an independent risk manager who reports to the CEO, has access to relevant information, and authority to block or initiate certain transactions. Corporate risk management should also be centralized but is often decentralized. Many corporations run the treasury as a profit center, which is not conducive to sound risk management. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Organizing the Risk Management Function in a Company (continued) Separation of front office from back office. Legal counsel, accounting, and auditing are critical, but accounting and auditing do not substitute for risk management. Risk management is a continuous process requiring regular evaluation and comparison to objectives. See Figures 16.1 and 16.2 for examples of typical dealer and corporate end user organization charts. Under enterprise risk management, the management of all risks is under a single area of responsibility. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting The concept of hedge accounting: accounting in which gains and losses on derivatives are tied to gains and losses on hedged instruments. In the U. S., the Financial Accounting Standards Board (FASB) has prescribed the appropriate methods of accounting for derivatives with FAS 133, Accounting for Derivative Instruments and Hedging Activities. Global standards are prescribed by the International Accounting Standards Board (IASB) with their IAS 39. In general, derivatives are marked to market and must appear on financial statements Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Fair Value Hedges: The firm is hedging the market value of an asset or liability. The gain/loss on the derivative as well as the instrument being hedged is recorded and reflected in current earnings. Example: Firm holds security and hedges with a derivative. Before the end of the hedge, the security loses $100,000 in value and the derivative gains $96,000. It does the following entries: Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Debit Derivative 96,000 Credit Unrealized Gain on Derivative 96,000 Debit Unrealized Loss on Security 100,000 Credit Security 100,000 This affects net income as well as the balance sheet. Income decreases by $4,000. Assets decrease by $4,000. These hedges must be properly justified, and carefully documented to be eligible for accounting this way. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Cash Flow Hedges: The firm is hedging the risk of a future cash flow. The derivative is marked to market and shows on the balance sheet but the gain/loss shows up in a temporary account, Other Comprehensive Income (OCI), which is an equity account. At the end of the hedge, OCI is closed out, and any balance adjusts the amount recorded to the cash flow being hedged. Also gains/losses must be separated into “effective” and “ineffective” components. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Cash Flow Hedges (continued) Example: A firm plans to borrow $1 million in six months by issuing a discount note. It buys an FRA to hedge. Rates go down and it incurs a loss on the FRA of $10,000. Eventually the FRA expires with a loss of $12,000 and the note is issued at 7%, generating a cash inflow of (1 - .07)$1,000,000 = $930,000. During the interim, it enters the following: Debit OCI 10,000 Credit FRA 10,000 Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Cash Flow Hedges (continued) When it takes out the loan, it enters the following: Debit Cash 930,000 Credit Notes Payable 930,000 Debit FRA 10,000 Debit OCI 2,000 Credit Cash 12,000 Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Cash Flow Hedges (continued) Debit Notes Payable 12,000 Credit OCI 12,000 Thus, it received $930,000 in cash and set up a liability of $930,000. It removed the FRA from the books and recorded a $2,000 further loss in OCI. It paid out $12,000 to cover the FRA loss and zeroed out OCI. It reduced the note balance to $918,000, reflecting the net amount of cash it received. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Cash Flow Hedges (continued) This was a perfect hedge. Suppose in the interim period the loss was $11,000 but the effective part was $10,000. Thus, the gain/loss on the derivative does not perfectly match the gain/loss on the hedged instrument. It would do the following: Debit Current Income 1,000 Debit OCI 10,000 Credit FRA 11,000 Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Cash Flow Hedges (continued) At expiration let the loss on the FRA be $15,000, of which only $12,000 is effective. Then we Debit FRA 11,000 Credit OCI 11,000 Debit Current Income 2,000 Debit OCI 1,000 Debit Notes Payable 12,000 Credit Cash 15,000 Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Cash Flow Hedges (continued) We remove the FRA from liabilities and all but $1,000 from OCI. We zero out OCI and reduce Current Income by $2,000. Notes payable goes from $930,000 to $918,000 (the Notes Payable entry above is the same), reflecting a loss of $12,000. Of the $12,000 loss, the ineffective part is $2,000, which goes into Current Income and combines with the $1,000 loss already in Current Income. There is still some uncertainty about how firms are to identify effective and ineffective parts of hedges. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Foreign Investment Hedges: Procedures for these had been in effect for a number of years. Certain transactions qualify for Fair Value and Cash Flow hedge accounting. Speculation: Gains/losses are marked to market and recorded in current income. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Some Problems in the Application of FAS 133 No clear prescription for what constitutes effective/ineffective hedging. Embedded derivatives must be separated. No hedge accounting for bonds held to maturity. Difficulty of arriving at derivatives’ values. Does not permit macro (firm-wide) hedges. Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Accounting (continued) Disclosure In the U. S., the SEC requires that firms using derivatives present either Tabular information on market values and contract terms, or Sensitivity analysis of potential losses, or Value-at-Risk Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Avoiding Derivatives Losses Four case studies: Metagesellschaft: To Hedge or Not to Hedge? Orange County, California: Playing the Odds Barings PLC: How One Man Blew up a Bank Proctor & Gamble: Going Up in Suds Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Management Industry Standards Professional organizations, such as PRMIA and GARP, help establish industry standards Risk management industry standards have been proposed by several different organizations at several different times, examples include: Group of 30 Report Risk Standards Working Group Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Responsibilities of Senior Management Senior management is ultimately responsible for all organizational activities. With respect to risk management, these responsibilities can be summarized as: Establish written policies Define roles and responsibilities Identify acceptable strategies Ensure that personnel are qualified Ensure that control systems are in place Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

An Introduction to Derivatives and Risk Management, 8th ed. Summary Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

An Introduction to Derivatives and Risk Management, 8th ed. This industry has reinvented itself in the last 30 years more than Madonna. Richard Sandor Futures Fall Special Issue 2005, p. 8 Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

An Introduction to Derivatives and Risk Management, 8th ed. (Return to text slide) Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

An Introduction to Derivatives and Risk Management, 8th ed. (Return to text slide) Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.