1. Treasury Control and Performance Evaluation Prof Ian Giddy New York University

2. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 2 Corporate Value at Risk l Position limits vs. “money at risk” l Sensitivity of positions to factors l How volatile are the factors? What is the 90% range (1.65 std dev.)? l “How much could I lose on my overnight/monthly position?”

3. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 3 A Corporate Foreign Exchange Application TRANSACTIONS FORECASTS FROM BUSINESS UNITS CONSOLIDATION NET POSITIONS, BY CURRENCY AND MATURITY VOLATILITY AND CORRELATION FORECASTS VALUE AT RISK

4. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 4 The VaR Management Cycle This process can be undertaken on a monthly cycle basis, as the institution revises its estimates of future business and as new data on volatilities and correlations are acquired.

5. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 5 The VaR Management Cycle PERFORMANCE EVALUATION

6. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 6 l Performance evaluation: “the science of attribution” l Example: Why did this taxi take so long?  The traffic; the driver; my lousy instructions? l How much should I tip this taxi driver? l Would I use this taxi company again? Why Measure Performance of Treasury?

7. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 7 Why Measure Performance of Treasury? l Like banks, treasurers face market risks, and must manage them l Unlike banks, exposures cannot be known with precision - so there’s no such thing as “fully hedged” l Hedging is a dynamic process l Making money is not enough - must be evaluated relative to cost and risk and capital allocated.

8. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 8 l Nokia: “performance measurement (selective vs. full hedge) is encouraged but not required” l Ericsson: “it is something we should look at” l Borealis: “no satisfactory relationship between risk and return” l Kværner’s qvestions:  Am I making money and if so, why?  How does my profit or loss relate to the risks that have been taken? Baltic Benchmarking

9. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 9 What Do We Want to Measure? l Return performance (did we outperform some benchmark measure?) l Risk reduction  Hedged positions?  Reduced earnings volatility (historical)?  Reduced Value at Risk (anticipated)? l Reporting, disclosure and problem identification (have we improved our risk measurement system?)

10. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 10 Risk and Return RETURN RISK

11. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 11 Kinds of Trading Risk for Performance Measurement l Corporate Risk Hedging vs Bank-within- the-Company l What Risks?  Position Risk  Basis Risk  Liquidity Risk  Counterparty Risk

12. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 12 Choosing the Right Yardstick: Return l Profitability - wrong! l Compare with “best practice” companies - wrong. l Compare with “forward rates” l Evaluate return relative to risk

13. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 13 TIME EXCHANGE RATE Spot Forward Actual Probability distribution of actual exchange rate Today In three months Unbiased Forward Rate Theory

14. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 14 The Risk Premium Theory

15. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 15 Performance Evaluation: Example

16. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 16 Performance Evaluation: Example

17. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 17 What Happened?

18. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 18 How Am I Doing?

19. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 19 Key Measures of Performance l Return: (Actual return - forward premium) l Return relative to risk (the “Sharpe” ratio):  Historical volatility of returns  Historical volatility of position value  Ex ante Value at Risk RETURN RISK

20. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 20 l The Sharpe ratio. (actual return relative to actual risk) l The risk ratio. (actual return relative to prospective risk) l The efficiency ratio. (actual risk relative to prospective risk) Use risk-return performance measures to evaluate individual trader performance. Using a VaR Measure for Trading-Portfolio Performance Evaluation

21. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 21 Performance Measurement: Roadmap FINANCIAL SIDE OPERATIONAL SIDE EXPOSURES n Known n Anticipated l Map exposures l Map risks l Manage risks l Measure performance l Take actions to improve performance MARKET PRICES MARKET VOL & CORR. RISK MEASUREMENT n VaR n Worst-case scenario, etc. RISK MANAGEMENT n Hedging n Investment or trading PERFORMANCE MEASUREMENT n Relative return n Relative risk. n INCENTIVES n ALLOCATION OF RESOURCES.

22. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 22 Sola Chemical

23. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 23 Sola Chemical l Tax planning - cerntralize? l FX exposure - Paper loss? Centralize to net exposures? l Transfer pricing and performance evaluation - 2nd set of books? l Sourcing funds - cheap local opportunities lost? l Other considerations?

24. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 24 l Performance evaluation: “the science of attribution” l Why did we make/lose money?  The market; the FX manager; my lousy instructions? l How much should I tip this FX manager? l Would I use this method again? l How good is my performance measurement system? Treasury Performance Measurement: Conclusion

25. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 25 Conclusion: Financial Risks and Shareholder Value n Interest rates n Currencies n Commodities Earnings Effect Economic Effect Shareholder Value?

26. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 26 Summary of “Value at Risk” Reporting “At close of business each day tell me what the market risks are across all businesses and locations.” Dennis Weatherstone, JP Morgan Logical steps:  Economic-value accounting (need market prices or models)  Market-price based performance measurement  Volatilities and correlations of market prices  Management of risk  Optimization of hedging

27. THE END

28. Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 28 Ian H. Giddy Professor of Finance NYU Salomon Center Stern School of Business New York University 44 West 4th Street, New York, NY 10012, USA Tel 212-998-0704; Fax 212-995-4220 Email: igiddy@stern.nyu.edu World Wide Web: http://stern.nyu.edu/~igiddy