13 Questions on Risk Management
   How are these financial instruments valu...


13 Questions on Risk Management

How are these financial instruments valued?

The supervisory board members must make a distinction between accounting principles and the valuation information needed to run the firm. While instruments may be valued at cost for accounting purposes, they must be valued at their market price (i.e. marked-to-market) for senior management because marking-to-market is a powerful information and decision-making tool. (Any other valuation method, such as historic rate rollovers, can be misleading to the firm’s managers.) Consider a firm that marks-to-market its bond portfolio and not its loan portfolio: if the issuer’s credit quality is deteriorating, the mark-to-market process will reflect the change through a falling bond price. The same information will typically take longer to be reflected in the loan values. Management is thus able to take more timely action in the marked-to-market scenario because marking-to-market alerts it to outside risks. The frequency of valuation depends on the nature, size and complexity of the instruments. (Large institutions mark-to-market daily.) Senior managers must determine the policy for obtaining market prices, including the supplier(s) of the prices and the frequency of marking to market.

These valuations must necessarily be carried out independently of those who trade the instruments. They must be checked or audited on a timely basis by someone who is independent of the trading unit. Failure to do so has created losses in many companies. In some cases, there may not be readily available market prices for products which have been customised to the specific needs of the firm. Senior managers should plan for such contingencies, making sure that quotations can be obtained from two other financial institutions before the firm is allowed to buy the instrument, or that there are people in-house able to value the product. The latter should be independent of the ‘risk-taker’ who bought the product originally.

Box 5
The mark-to-market gospel at General Motors and Caterpillar
At the end of 1995, General Motors held foreign exchange-forward contracts totalling $11,602 million notional (inclusive of cross-currency swaps with a nominal value of $1,290 million). It had also entered into currency options of approximately $3,833 million. Deferred hedging gains on outstanding contracts hedging firm commitments to purchase inventory or fixed assets totalled $1 million. Its 1995 annual report states, «Such amounts are deferred and will be included in the costs of such assets when purchased, to be recognised in operations as part of the basis of these assets. All other foreign exchange-forward contracts and options are marked to market, and recognised with other gains or losses on foreign exchange transactions in the Consolidated Statement of Income.»

The company had a notional amount of $15,942 million of interest rate derivatives at the end of 1995. «Gains and losses on terminated interest rate forward contracts are deferred and recognised as a yield adjustment on the underlying debt. Unamortized net losses on interest rate forward contracts totalled approximately $36 million at December 31, 1995. Written options, including those embedded in interest rate forward agreements , written interest rate caps, written swaptions, and interest rate forward contracts that do not meet settlement accounting criteria are marked to market with related gains and losses recognised in income on a current basis.»

Caterpillar sells more outside the US ($8.3 billion in 1995) than it does in its home country ($7.42 billion in 1995), so the company has substantial currency exposure. Foreign exchange movements affect the US dollar value of sales in foreign currencies, the US dollar value of costs incurred in foreign currencies and the company’s competitive position vis-ŕ-vis non-US based competitors.

The company uses over-the-counter forward foreign exchange contracts and options to manage its currency exposure with the objective of maximising consolidated after-tax US dollar cash flows. Caterpillar states categorically that «it does not use historic rate rollovers» to help it deal with the impact of currency fluctuations on its core business.


See also: Over The Counter (OTC)


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