FRM 2: How Do Firms Manage Financial Risk?
Every company has always looked after the risks inside its own trade. Managers study what moves customer demand, keep more than one supplier for a critical component, and insure the warehouse. Financial exposures received nothing like that attention for most of the twentieth century, and what changed is a mix of need and opportunity.
The need
From the 1970s onward, markets in commodities, interest rates, credit and foreign exchange were liberalized one after another. Prices that had once moved inside official bands began to move on their own, volatility climbed sharply, and trade spread across borders as the global economy gathered pace.
The opportunity
That same volatility created a market. Instrument types multiplied quickly after the 1970s, helped by theory, in particular the Black-Scholes-Merton option pricing model, and by securitization, in which loans and receivables are pooled and securities issued against the pool. Mortgage-backed securities, asset-backed securities and collateralized loan obligations belong to that family. Credit derivatives and weather derivatives arrived in the 1990s, and cyber risk transfer instruments have been emerging since the twenty first century opened.
Notional volumes in the principal over-the-counter derivatives markets grew heavily between 1999 and 2019, counting both trading and end-user risk management, then flattened out in several categories. Three forces sit behind that levelling: speculative use fell away, bank regulation tightened, and both interest rates and market volatility declined after the 2007-2009 global financial crisis. Other transfer markets, cyber risk among them, are still expanding quickly.
The questions a firm has to answer first
None of this settles whether a particular firm should act. The board still has to decide whether managing risk serves the owners at all, what the strategy is for, how much exposure to keep, and which instruments suit the job. Poor answers turn the programme itself into one of the larger threats facing the company.
Corporate risk management runs along a path with five recognisable milestones, drawn here as a line although the work loops back constantly. Once a firm sees what risk management costs in a business unit, the honest response may be to ask whether it wants to be in that risk-generating activity at all.
What sits inside each milestone
The first milestone names the key corporate goals and their attached risks, asks which risks are worth managing, and produces a risk appetite statement in broad terms. The second maps the exposures, measures their size and impact, runs a risk and reward analysis of the proposed strategy using a measure such as RAROC, weighs the costs and benefits of competing tactics, and ends with a chosen strategy and a detailed appetite statement.
The third converts appetite into operating language: policies are assessed, a limit framework is set, and the team is right sized for resources, expertise and infrastructure, with attention to incentives and independence. The fourth chooses tactics and instruments, takes the daily decisions and establishes oversight. The fifth is regular re-evaluation, catching shifts in appetite and in stakeholder viewpoints, changes in business activity that call for remapping, and the arrival of new tools and tactics.
Instruments built to hedge economic exposures carry consequences of their own. A derivatives position can rework the shape of a firm’s risk profile inside days or even hours, and the same trade may cut exposure or open a speculative one, with the direction not always obvious from outside, or from inside.
Take a company exposed to a variable interest rate. It buys a complicated instrument that dampens the exposure so long as rates stay within certain bounds. Break through the ceiling written into the structure and the instrument stops protecting the firm and starts enlarging its exposure. Whether the trade is risk management or a bet then depends on where rates end up, which is a poor basis for describing a hedging programme to a board.
Ordinary corporations can now hold risk profiles that once belonged to investment banks, and much of what firms spend on corporate risk management exists to keep that capability in sensible hands.
Hedging philosophy: possible is not the same as advisable
A risk being hedgeable does not settle whether it ought to be hedged. Hedging is a tool, and tools have limits. One limit is horizon, since a hedging programme holds earnings steady across a few years and no longer. Another is cost. Some costs are visible, the option premium being the obvious one, and others are hidden, including the damage done by tactical errors and by rogue trading. Set against those, the owners may believe the exposure is already diversified away inside their own portfolios.
Against those objections sit several arguments that hold up in practice, each turning on a market imperfection that finance theory assumes away.
Financial distress is expensive
Hedging often exists to lower the chance of financial distress, which carries two kinds of cost. Direct costs come first, bankruptcy costs among them. Then come the opportunity costs, since a firm absorbing an unexpected market loss cuts investment elsewhere and turns cautious at exactly the moment its competitors are moving fast.
Steady revenue speaks to creditors, customers and suppliers
Lenders receive no share of the upside when revenue swings in a firm’s favour. Their only question is whether the promises get kept, so a smoother revenue line reads as a stronger credit. Key customers and important suppliers weigh the firm the same way.
Hedging can raise cash flows rather than merely calm them
Suppose customers will sign only if the firm holds a price steady for the next three years. Without a hedge on the key cost input, that offer cannot be made safely. If it wins business, cash flows rise and equity investors are better off whatever they think about volatility. A firm that has agreed to supply a product into a foreign market in one year’s time faces the same logic, since hedging the currency locks in the margin on a deal already signed.
The planning benefit
For managers this may be the most valuable effect of all. A currency wandering at random turns budgeting, capital allocation and pricing into guesswork, and fixing the rate makes the future concrete enough to plan around.
Other stakeholders, and their incentives
Shareholders are not the only decision makers. Managers, regulators and staff all want a sound firm protected against sudden accidents. Managers carry an extra motive, since hedging helps them hit short-term targets such as stock analyst expectations, and those targets affect their standing and their pay. Risk managers have to watch how derivatives amplify agency risks of that kind. Firms should state the aim of a hedging programme plainly, whether the target is economic risk, operational risk, balance-sheet risk or accounting risk, and be equally plain about the size of the appetite behind it.
Two terms sit close together and mean different things. Risk appetite covers the amount of risk, and the kinds of risk, a firm is prepared to take on. Risk capacity is the ceiling, the most it could absorb at all. Appetite is a choice, capacity is a constraint, and prudent firms leave a gap between them.
Capacity is sometimes set by a regulator rather than by the firm. A bank may not let its leverage ratio fall below 3%, where the ratio compares tier 1 capital with assets plus off balance-sheet exposures.
Risk appetite is two things at once
First, it is a statement of how much risk the firm will run in pursuit of its business goals, normally an internal document approved by the board, with a shortened version sometimes reaching the annual report. Second, it is the set of mechanisms connecting that statement to what happens on an ordinary Tuesday: the detailed risk policy, risk statements for individual businesses, and the framework of limits covering each key risk area. This operational expression needs board approval too, and it must line up with every other signal the firm sends its staff, incentive compensation included. Banks, pushed by regulators and a run of crises, have taken it furthest.
Which meaning of appetite is the right one
The phrase gets used loosely in business writing. Does appetite mean everything the firm could bear before insolvency, or the risk it happens to be running today, or the quantity it would be content to carry at any single moment? The third reading is the one used when appetite is drawn as a metric.
A third term, risk tolerance, is often set beside the other two, and the literature does not use any of the three consistently. In one common usage tolerance names the quantity a firm would be content to bear at any one time, with capacity kept as the insolvency ceiling. A board cannot approve limits built on words that change meaning between documents, so each firm fixes its own definitions.
Firm-level appetite is not the risk appetite in the business press
Economists survey business leaders about risk appetite and publish the results as a gauge of how eager companies are to invest and expand. That reading is a barometer of industry sentiment at one point in time, pushed about by conditions in the wider environment. A firm’s own appetite is a different object, a through-the-cycle attitude toward risk meant to hold reasonably steady while sentiment swings.
Appetite is not one dial set to one number, and it varies by risk type inside the same company.
A high-technology firm might adopt a strategic objective that looks dangerous from outside, on the view that failing to outrun its competitors would leave it with no purpose at all. Placing that bet is risk management for such a firm. The same company can be thoroughly conservative about foreign exchange exposures with no inconsistency, and it may handle cyber risk far more explicitly than a self-described conservative firm across the road.
Appetite belongs to identity
Appetite is bound up with what a firm is and what it can do. Two questions come before any attempt to turn it into numbers. What kind of firm is this, and what kind of firm do its stakeholders believe they are dealing with?
Why the link to operational metrics is hard
Building a robust connection between a top-of-house appetite statement and the operating metrics of one risk type or business line is genuinely difficult. No single measure of risk, even inside one risk type, both monitors risk at business level and adds up cleanly to the enterprise level. Firms respond with a collection of measures rather than one.
For a financial firm that collection typically includes notional limits set by business and by risk type, estimates of unexpected loss, versions of value-at-risk, and stress testing. How much detail is warranted depends on the nature of the risk and on how sophisticated the strategy around it is, since an annual insurance purchase does not need the apparatus of a dynamically managed trading book.
What a published risk appetite statement contains
A large international bank makes the connection concrete by attaching metrics, some quantitative and some qualitative, to each risk category it cares about. The list typically covers credit risk, traded risk and operational risk, alongside earnings, liquidity and funding, capital and leverage, interest rate risk in the banking book, financial crime compliance and regulatory compliance. Measurement against those metrics does several jobs at once. It guides what the businesses are allowed to do, it feeds risk-adjusted remuneration, it keeps the assumptions underneath the plan under review so that later planning cycles can adjust them, and it surfaces quickly the decisions needed to bring a risk back down. The board approves the statement on the advice of its risk committee. From there it runs through the annual planning cycle, with each global business, geographic region and function writing an aligned statement of its own, so the group holds a risk profile for every unit.
The appetite statement says what the firm is trying to achieve, and mapping says what it is actually exposed to. The work is done at the level of cash flows, with the size and timing of each exposure set against a particular horizon.
Mapping a commodity exposure
A manufacturer may face a large commodity price risk through its production line, the price of copper being a typical case. The risk manager starts with quantities and dates: how much copper must be held in stock, when the metal is needed, and where it has to be delivered. One further question decides the hedge, namely which local price benchmark comes closest to the firm’s actual risk. Choose the wrong benchmark and the hedge tracks something the firm does not buy.
Mapping a foreign exchange exposure
Here the first step is an inventory: positions on the books, contracts signed, and transactions expected soon. Policy then states which exposures get hedged, a genuine choice, since sales that are probable but not yet certain may be included or excluded. The firm also needs the timing of each cash flow and a view of which assets and liabilities move with exchange rates.
Mapping frequently reveals that flows cancel one another out, sometimes by design and sometimes by accident. Spotting those netting and diversification effects is one of the main returns on the exercise, since a firm can then plan to create more of them rather than paying a bank to hedge an exposure it does not really have.
The exposures that resist mapping
Some risks call for insurance rather than a derivative: natural catastrophes, physical mishaps and cyber incidents. Mapping should also reach exposures that are awkward to trace through the accounts. A new business line may bring large data privacy risks nobody can size confidently alongside foreign exchange exposures that are easy to size, and leaving the first group out because it resists measurement is how firms end up surprised.
With appetite understood and the exposures mapped, every risk can be assigned a strategy. The risk manager first decides which exposures matter most, asking which are the most severe and which the most urgent, and the firm weighs costs against benefits. Four approaches are available.
Retain
Some risks the firm accepts whole, others in part, taking a slice of the loss distribution and passing on the rest. Retained risk is not automatically small risk. A gold mining company may keep gold price risk because that is the exposure its investors came for, and an input price risk behaving like an expected loss can be priced into the product. Deciding deliberately to keep a risk is as much risk management as hedging is.
Avoid
Firms often judge a category of risk unnatural to their business, and some exposures can be avoided only by shutting down the activity that creates them. Companies like to announce zero tolerance for a kind of risk or behaviour, and without real safeguards behind it the announcement describes a hope rather than a state of affairs.
Mitigate
Mitigation cuts the exposure while keeping the activity. Additional collateral demanded by a lender reduces its credit risk. Aircraft bought for better fuel efficiency reduce an airline’s jet fuel exposure for every year they fly.
Transfer
Part of a risk can be handed to a third party at a price, through insurance contracts, financial derivatives or securitization. The board and senior management pick the strategy for the larger risks, and the risk manager helps them compare options against one test: which keeps the firm inside its appetite at the lowest real cost?
Real cost is rarely transparent. The price of transferring a risk ought to include the salary of the risk manager running the programme and the handling of whatever residual risk survives, normally basis risk. Business judgement matters as much as arithmetic, above all for exposures that resist quantification.
Expert judgement puts a 5% chance on a data loss event costing USD 100 million in the coming year. A data systems upgrade costing USD 12 million spread over four years would cut the annual probability to 2%. Cyber insurance covering USD 60 million of the loss is quoted at USD 2.4 million a year.
A strategy is only as good as the team asked to run it. Once goals are set in the key risk areas, the firm has to match the size of its risk management function to the ambition of the strategy.
Moving a familiar risk with a single market hedge, or buying insurance once a year, is simple enough work. A dynamic strategy readjusted continually in the markets is a different proposition. Such strategies demand far more investment in systems and trader expertise. They may oblige the firm to build complex models, apply metrics such as value-at-risk, and operate a wider limit system. Keeping the trading function apart from the back office and from risk oversight also matters more as the strategy grows more active.
Firms using sophisticated instruments without the staff to match end up dependent on their suppliers, typically investment banks, and the clearest symptom is an inability to price an instrument independently. Several times a year the board should run a gap analysis asking whether its level of sophistication still matches the boldness of the strategy.
Checking that the function is fit for purpose
The review settles the risk appetite and hedging philosophy, and the basic goals behind the programme, which may be reducing volatility, improving how sound the market believes the firm to be, reducing taxes paid, or reducing the risk of limit breaches. It fixes the accounting treatment, meaning cost centre, economic centre or profit centre. It states which risks are covered, among them financial risk, operational risk, business risk, reputational risk and strategic risk, and over which horizons. It then right sizes resources and budget, sets reporting lines and oversight with attention to independence, documents policy, and specifies how performance is evaluated.
Cost centre or profit centre
Most non-financial firms treat risk management as a cost centre, while some banking activities run it as a profit centre, which lets the desk take a view rather than merely neutralise exposure. A related question follows: should the costs be pushed out proportionally to the businesses the function serves? Both answers depend on the organisation’s risk culture and appetite rather than on any general rule.
Limits are where risk appetite stops being a document and starts constraining behaviour. Each type controls something different and each has a blind spot, which is why firms run several kinds together rather than picking a favourite.
| Limit | What it controls | Weakness |
|---|---|---|
| Stop loss | A loss threshold with an action attached, such as closing out or escalating | Caps losses already realised and does nothing to prevent future exposure |
| Notional | The notional size of an exposure | Notional amount can sit a long way from the economic risk of a derivative, and options are the worst offenders |
| Risk specific | A particular feature of the risk in question, such as liquidity ratios used for liquidity risk | Hard to aggregate across a firm, and interpreting them can require specialist knowledge |
| Maturity or gap | The volume of transactions maturing, resetting or repricing in each period | Eases the operational and liquidity strain of a crowded period, yet speaks to price risk only indirectly |
| Concentration | Concentrations by individual counterparty or by product type | Must be set with correlation risks in mind, and may miss correlations that appear only in stressed markets |
| Greek | Option positions capped by their own risk characteristics, delta, gamma and vega risk included | Carry every classic model risk, and the calculation can be compromised at desk level without controls and independence |
| Value-at-risk | An aggregate statistical figure for the portfolio | Carries the classic model risks, is easily misread by senior management, and says nothing about how bad a loss becomes in an unusually stressed market |
| Stress, sensitivity and scenario | How bad a plausible worst case could get: stress tests apply specific stresses, sensitivity tests move key variables, scenario models run hypothetical or historical situations | Sophistication varies, results rest on deep knowledge of exposures and market behaviour, and the supply of scenarios never runs out |
Source: limit types and weaknesses as set out in the chapter, restated for study purposes.
A pattern runs down the weakness column. Simple limits are easy to monitor and easy to game, while statistical limits capture more of the portfolio and import model risk with it.
When a risk manager moves part of a financial exposure into the risk management markets, the instruments available fall into four broad families: swaps, futures, forwards and options, each shaped for a different job.
A forward is a tailored contract under which a set quantity of an asset changes hands on a future date at a price fixed today, settling by physical delivery or in cash against a specified spot price. A future is the exchange-listed version, standardised in its terms and margined. A swap is an over-the-counter agreement to exchange the cash flows, or the value, attached to two different economic positions, through the life of the contract or at its maturity. In an interest rate swap one side pays a fixed rate on an agreed notional amount while the other pays the variable rate, and the form varies with the underlying market.
Options split the two directions apart. A call option buyer may purchase the underlying asset at a strike price agreed in advance and is never required to, on the maturity date under a European option or at any point in the period under an American option. A put option buyer holds the matching right to sell. Beyond these plain vanilla contracts sits a list of exotic options, Asian options settling against an average price and basket options referencing a basket of prices among them. A swaption confers the right, again without obligation, to enter a swap later on pre-agreed terms.
Paying for flexibility
Choosing between them is largely a question of how much a firm will pay to keep its choices open. A forward delivers price stability and very little flexibility, since the trade must happen at the stated time and price whatever the market has done. A call option delivers stability and flexibility together, and the option premium is what that combination costs.
A second distinction cuts across the instrument families and concerns trading mechanics. Is the contract offered through one of the large exchanges, or is it a private bilateral agreement negotiated over the counter? The two routes differ most in liquidity and in counterparty credit risk.
The exchange route
Exchange-based derivatives are built to pull in trading liquidity. Not every one succeeds, and most trade easily at a fairly low transaction cost. Standardisation is what makes that liquidity possible, and it is the drawback too, rather like buying a suit off the rack when the fit matters. The available futures contract may reference a slightly different grade, mature on the wrong date, or price the commodity in the wrong location. Each gap leaves the firm exposed to basis risk, the risk that hedge and exposure move apart.
On credit the exchange route is stronger, since margin requirements and netting arrangements keep counterparty credit exposure small, with collateral collected daily rather than a promise trusted for months.
The over-the-counter route
A private agreement can be written around the real exposure, which is the point of it: the right grade, the right date, the right delivery location. Counterparty credit risk here tends to look modest right until a financial crisis arrives, at which point banks and other counterparties can start to look fragile at once. Clearing houses have taken a larger role in these markets, and the old contrast in counterparty risk between the two routes has narrowed as a result.
Modern risk management arguably begins in agriculture, with the futures that the Chicago Board of Trade (CBOT) started listing in the 1860s. The United States brewer Anheuser-Busch carries large exposures across barley, hops, wheat, corn syrup, corn grits and other agricultural inputs, as well as the aluminum in its beer cans and the energy used in brewing, and it hedges them with derivatives.
| Commodity derivative | Notional outstanding (USD millions) |
|---|---|
| Aluminum swaps | 1,670 |
| Exchange-traded wheat futures | 424 |
| Natural gas and energy derivatives | 313 |
| Corn swaps | 196 |
| Rice swaps | 194 |
| Plastic derivatives | 84 |
| Exchange-traded sugar futures | 62 |
Source: 2018 Annual Report of Anheuser-Busch InBev, commodity price risk in Section C, page 135.
Wheat through the exchange
The price paid per bushel can be fixed with CBOT wheat futures held for some months to maturity. The brewer then takes delivery on the terms the exchange sets, or sells the contracts near the delivery date and spends the proceeds with whichever supplier it prefers. Either way the price risk of that period has been handled through a liquid listed contract.
A brewer needs 500,000 bushels of wheat in five months and buys 100 CBOT wheat futures of 5,000 bushels each at USD 5.40 per bushel. Five months later it buys the wheat from its preferred supplier at a spot price of USD 6.10 per bushel and closes the futures at USD 6.00.
Aluminum through a bilateral swap
Beer cans are a different matter. The brewer agrees a swap with a bank under which a fixed sum changes hands every few weeks for a set quantity of metal, while the bank returns the floating price local suppliers are charging. Tailoring the contract addresses the basis risks thrown up by the production schedule, both the weeks the metal is wanted and the variation in local pricing. A sharp rise in aluminum would leave the bank with a heavy loss, although in practice it offsets the position in the metals markets and keeps a margin. The brewer has fixed the cost of an input that otherwise moves with tariffs and with sanctions on producing countries.
Airlines burn as much as 15-20% of their operating costs in the air, and competition stops them passing an oil spike into fares, since ticket prices track consumer demand rather than airline costs. From the mid-1980s the industry has worked this exposure with swaps, call options, collars built from calls and puts, current oil contracts and other instruments. The market matured quickly once energy prices spiked during the 1990-1991 Gulf War, which is how a good many risk transfer markets begin.
Cross hedging a fuel with almost no futures market
Jet fuel itself has few futures contracts. One way round that uses liquid exchange instruments on crude oil, or on another oil product such as heating oil, which leaves the airline carrying the spread between jet fuel and crude. That spread has to be hedged in its own right alongside the usual timing and location basis. Tailored over-the-counter contracts are the alternative.
Whether to hedge at all
Decades on, the industry still disagrees. Most carriers hedge a portion of the burn and some retain all of it. Critics point at the expense and at the danger of fixing a price near the top of the market just before a slide. Because almost no carrier is 100% hedged, a falling price still helps overall; the hedging losses simply leave the hedged airline looking weaker than rivals who did nothing. American Airlines, carrying no hedge, reported a bumper 2014 on the back of a 40%-50% fall in the price of jet fuel and USD 600 million of savings, and several hedged competitors scaled back afterwards. Going unhedged is equally a bet. Oil reached unexpected highs in 2008 as a financial crisis engulfed the world, and the carriers running the tightest programmes were the ones who looked shrewd.
An airline expects to burn 400 million gallons of jet fuel next year and budgets at USD 2.00 per gallon. It hedges 60% of the volume with swaps struck at USD 2.00 and leaves the rest floating. Jet fuel then falls 45% to USD 1.10 per gallon.
Hedging part of the burn, buying options and entering long forward contracts on jet fuel all soften the choice, and options, arguably the purest form of risk management here, are expensive to put in place. Delta Air Lines took another route in 2012, buying an oil refinery as part of its fuel management strategy, which has helped it secure supply in one region and cover some of the gap between jet fuel and crude prices. Because jet fuel is only a fraction of refinery output, ownership arguably deepens rather than reduces sensitivity to crude oil prices.
Interest rate and foreign currency exposures reach almost every large firm. McDonald’s, present in over 100 countries, sets both out in its Form 10-K for fiscal 2017. Long-dated borrowing leaves it sensitive to rate moves and currency moves alike, and debt obligations stood at USD 29.5 billion on December 31, 2017, against USD 26.0 billion on December 31, 2016. Capital markets, bank financings and derivatives cover its financing requirements, and the debt portfolio is reshaped by retiring or repurchasing debt and by terminating swaps. None of those instruments are held for trading, and every swap is an over-the-counter contract. On the currency side the company borrows in the currencies its assets are denominated in, and pairs foreign currency debt with derivatives against royalties, intercompany financings and long-term holdings in affiliates and foreign subsidiaries. Such debt came to USD 12.4 billion in 2017 and USD 8.9 billion in 2016, and restaurants buying goods and services locally supply natural hedges on top.
Natural hedges come first
Inside a large firm many exposures already cancel one another. Ordinary business activity manufactures natural hedges, currency flowing in and out being the plainest instance, and derivatives frequently do no more than fine-tune a profile that operating decisions have already set. Borrowing in the currency of an overseas operation would shrink the foreign exchange exposure, and some markets will not supply that debt on workable terms.
The interest rate balancing act
The task is to avoid carrying too much debt taken on at high interest rates, and to avoid leaning too heavily on variable rates. Two things set the balance: the financial risk appetite, which may state the debt levels the board accepts, and the split between fixed and variable interest across several time horizons. That appetite has to sit comfortably with the target credit rating and with covenants given to banks and other financing providers.
The environment moves even when appetite does not. Debt matures, financing needs shift as businesses grow and deals roll over, and regulations and taxes change. Market practicalities matter too, since raising money wherever it is cheapest and then converting the currency, or the fixed and variable characteristics, through derivatives is often the easier path. Where treasury runs as a profit centre rather than a cost centre, the treasurer may take a directional view, preparing for rising interest rates or responding to the yield curve. Relationships between maturities move as well as the level of rates, which is yield curve risk, and variable rate debt repricing downward acts as a natural hedge while business conditions deteriorate. Over-the-counter interest rate swaps and currency swaps are the standard tools, and the choice among them returns each time to what the appetite directs.
A firm holds USD 800 million of floating rate debt priced at the reference rate plus 120 basis points. It enters a swap on a notional of USD 500 million, paying a fixed 3.10% and receiving the reference rate.
Everything can go wrong. A firm can misread the type of risk it faces, map or measure it incorrectly, miss a change in market structure, or discover a rogue trader on the desk.
Programmes that were never about risk
Trouble often starts with a programme built for another purpose. Using derivatives to cut the interest a firm pays sounds reasonable enough. What the hedger accepts in exchange may be a great deal more downside, or a payment structure that stays cheap now and balloons later. Programmes of that shape usually exist to flatter reported returns against analyst forecasts, or to cover a problem in the underlying business. The worst pile on leverage and elaborate structures that unravel once something improbable but plausible occurs, a jump in interest rates or a widening of basis risk being the candidates. Failures like these belong to corporate governance rather than to risk management.
MGRM, 1993
Poor communication about a strategy and its consequences is the purer case. MG Refining and Marketing, known as MGRM, traded energy in the United States for Metallgesellschaft AG. It had contracted to deliver 150 million barrels of gasoline and heating oil at fixed prices spread over ten years, covering that commitment with an oversized rolling book of short-dated futures and over-the-counter swaps.
Carried through to the end, the strategy might well have worked. The oil market changed shape first. Cash prices fell and the curve moved out of backwardation into contango, at which point the programme threw off margin calls large enough to drain cash severely and without warning.
The alarmed parent company liquidated the hedges at a considerable loss. The market then turned and ran against MGRM, which by then held no hedge at all, and the original customer contracts produced even bigger losses. No rogue trader appears anywhere in the story. Management that had worked through the liquidity consequences of hedging with futures could have reserved capital against the calls and kept the hedge alive, or chosen a structure making lighter collateral demands.
A short list of unglamorous habits would have prevented many risk management disasters.
- Fix clear goals for the programme before choosing any instrument.
- Hold instruments and strategies to the simplest form that does the job.
- Disclose the strategy and spell out what follows from it.
- Match resources and limits to the strategy actually being run.
- Run stress tests, and build early warning indicators.
- Keep an eye on counterparty risk and on break clause risk.
- Work through many different market scenarios, margin calls included.
There are no silver bullets. Firms have to understand their business exposures and the natural hedges already sitting inside them, justify a hedging philosophy, set a risk appetite, and connect it to specific goals and to practical levers such as a risk limit framework and a properly sized risk management function. The goals and the strategies then have to be communicated, so that consequences are understood in advance and expectations are managed.
Risk culture can be assessed
The least tangible requirement is a culture in which everybody pulls toward the same end, and it is not beyond examination. Three questions test it. Can the firm show that it communicates about risk regularly and reacts to warning signs and near misses? Has it checked whether key staff share one understanding of the risk appetite? Can it demonstrate that the board knows the firm’s top ten risks?
Nobody hears about the hedges that worked, or about the firms that would have collapsed without a well-managed and well-communicated hedging programme. Practitioners nonetheless expect end-user activity in the derivatives markets to keep growing. In an industry survey published in April 2018, with 43% of respondents drawn from buy-side firms, most expected end-user hedging and trading to increase over the following three to five years.
The point carries down to the individual. Someone who stabilises a volatile business exposure across a three-year time horizon has done difficult work, and deserves to know the achievement forms part of a larger plan backed across the firm.