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13 Questions on Risk Management
What type of financial instruments may the firm use?
All firms should have a list of approved financial instruments, including derivatives. Each instrument must be clearly described together with an analysis of its usefulness in relation to other activities and the firm’s financial condition, together with reasons for its use. The continuum of financial instruments must be covered, and the list should distinguish between non-derivative (cash instruments such as fixed-rate bonds), plain vanilla derivatives (e.g. a currency swap or an outright call option on Nestle shares), exotic products (often more complex options, e.g. a lookback option), hybrids (e.g. fixed-rate bonds with options embedded in them) and leveraged derivative products (a specific type of derivative financial instrument containing a formula or multiplier, which for any given change in market prices, could cause the change in the product’s fair value to be several times the change in the value of a similar product without the formula or multiplier.) A comprehensive list will prevent products inadvertently slipping through the net. For example, a five-year plain vanilla fixed rate bond issued by the World Bank is very different from a World Bank five-year fixed rate issue whose redemption value is tied to the Nikkei 225. Because the latter has a Nikkei 225 option embedded into it, it will not pass muster with a board which does not want to sell options in any form.
Senior managers must ensure that all the risks arising from these approved instruments can be measured and controlled by the existing risk management system.
The drill prior to using a new product must also be in place from the start and not drawn up only when the firm is thinking of buying or offering a new product . All relevant personnel, including senior managers must understand a new instrument before the firm may become involved. Before a new product is introduced, senior managers must ensure that all its risks are identified and integrated into the risk measurement and control system. New instruments require senior management approval before the firm starts trading them. Also important is the green light from the internal auditors - they must be able to understand a new product and have confidence that all its attendant risks can be measured and controlled before giving their go-ahead.
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