13 Questions on Risk Management
   Who formulates the firm’s guidelines and...


13 Questions on Risk Management

Who formulates the firm’s guidelines and policies on the use of financial instruments?

Senior managers (including executive members of the board) should formulate the major policies and guidelines of an institution. The policies must cover how and when financial instruments, particularly derivatives, may be used in the broadest terms; with procedures sufficiently detailed to prevent inadvertent speculation. The Gibson Greetings and Procter & Gamble experiences highlight the need for very comprehensive guidelines. These policies must be drawn up in line with the institution’s capital base, its broader business aims, its risk culture and its overall ability to manage and control risk.

Policy makers should also decide whether the firm can pursue an aggressive hedging policy; i.e. hedging both anticipated and existing transactions as well as allowing clearly mismatched hedges in order to reduce costs. If the board condones an aggressive hedging strategy, then it must accept the dangers of open risk positions inherent in such a strategy. To prevent an aggressive hedging strategy from being used as a smokescreen for speculation, senior managers must set down all of the circumstances under which such transactions are permitted. These policies and procedures should also cover proprietary trading, including a list of people who are allowed to transact proprietary trades. In end-user firms (non-financial institutions), senior managers should designate the people who are allowed to trade financial instruments and the managers to whom these ‘risk takers’ are accountable. Such a list enables the board of directors to pinpoint who is accountable for the financial risks of the company.

The guidelines must cover the general areas of financial policy, credit risk, market risk, legal issues, human resource guidelines, accounting and reporting considerations, as well as management information and internal control systems.

Box 1
No ambiguities please
General Electric is one of the largest non-financial users of derivatives, with outstanding notional amounts of $104 billion at the end of 1995.

The company’s policy on financial instruments is clearly stated in its 1995 annual report. Senior managers note in the Management’s Discussion of Financial Resources and Liquidity: «Both General Electric and GE Capital Services are exposed to various types of risk, although the nature of their activities means that the respective risks are different. The multinational nature of GE’s operations and the relatively low level of GE’s borrowings means that currency management is more important than managing exposure to changes in interest rates.

«On the other hand, changes in interest rates are the more significant exposure for GECS because of the potential effects of such changes on financing spreads.

«The correlation between interest rate changes and financing spreads is subject to many factors and cannot be forecast with reliability. Although not necessarily relevant to future effects, management estimates that, all else constant, an increase of 100 basis points in interest rates for all of 1995 would have reduced GECS’ net earnings by approximately $65 million.

«GE and GECS use various financial instruments, particularly interest rate, currency and basis swaps, but also options and currency forwards to manage their respective risks. GE and GECS are exclusively end users of these instruments, which are commonly referred to as derivatives; neither GE nor GECS engages in trading, market-making or other speculative activities in the derivative markets. Established practices require that derivative financial instruments relate to specific asset, liability or equity transactions or to currency exposures.» [This is unlike Caterpillar, which manages its total foreign currency exposure arising from firmly committed and anticipated transactions for a future rolling twelve-month period but does not hedge specific asset or liability positions.] «Interest rate and currency swaps are employed by GE and GECS to achieve the lowest cost of funds for a particular funding strategy. GECS enters into interest rate swaps and currency swaps (including non-US currency and cross-currency interest rate swaps) to modify interest rates and/or currencies of specific debt instruments. For example, to fund US operations, GE Capital may issue fixed-rate debt denominated in a currency other than the US dollar and simultaneously enter into a currency swap to create synthetic fixed-rate US dollar debt with a lower yield than could be achieved directly. Such interest rate and currency swaps have been designated as modifying interest rates, currencies, or both....... «GECS used a portion of this interest rate swap portfolio to convert interest rate exposure on short-term and floating-rate long-term borrowings to interest rates that are fixed over the terms of the related swaps; interest rate basis swaps also are employed to manage short-term financing factors - for example, to convert commercial paper-based interest costs to prime rate-based costs.» At the end of 1995, these swaps had maturities ranging from 1996 to 2029, and a weighted average interest rate of 6.86%.

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