Implementing an Integrated Risk Management Program

1. Implementing an Integrated Risk Management Program

2. Why does a Firm Need an Integrated Risk Management Program? • To Avoid Derivatives Debacles – Large derivatives-related losses have been making headlines since the early 1990s (e.g., Codelco, Gibson Greetings, P&G, Mead, etc.). Usually due to poor controls, weak oversight, and/or ignorance. • To Remain Competitive / Gain Advantage – Hedging programs can be initiated to provide strategic advantages in terms of pricing products, protecting operating margins, creating new products/services, and improving customer relations.

3. Lessons Learned from the Past: • “For most companies the question is how to be involved with derivatives, not whether to be involved” – Moody’s Investors Service. • Rule 1:“Make Sure You Know How Much is at Risk” (VAR and Cash Flow Sensitivity analysis can help accomplish this). • Rule 2: “Make Sure That Everyone is on the Same Page” (this requires that risk management policies and procedures are established and clearly communicated).

4. Risk Management Cycle Set Goals Identify and Quantify Exposures Evaluate and Control Define RM Philosophy

5. Risk Management Cycle (cont.) • Goals for Risk Management – Should the RM team be a profit center? Reduce CF volatility? Decrease Equity volatility? • Identify & Quantify Exposures – again, VAR is not the only valid risk measure. Stress-testing, duration, scenario analysis are other ways of looking at risk. • Defining an RM Philosophy – three broad types: • Integrate different Market Risks (within Treasury dept.). • Integrate Market and Property/Casualty Risks. • Integrate Market Risk throughout the firm (Strategic RM). • Evaluate & Control – must be independent of the hedging/trading activity.

6. Implementation Issues • Derivatives vs. Natural Hedges / Liquidity Management – e.g., can locate assets and liabilities in same country or hold excess liquidity to hedge rather than use derivatives (but can be costly in terms of flexibility and profitability). • Passive vs. Active Management – if markets are efficient, there no real gains to active management. • Define Ground Rules – must define what instruments, purposes, and amounts can be hedged (and by whom). • Counter-party Risk – derivatives are credit instruments and therefore the firm must manage this inherent risk.

7. Role of the Board of Directors • Approve Risk Management Policies. • Ensure Capabilityof people that have been delegated the authority to execute the policies. • Evaluate Performanceof the risk management team and make sure that the evaluation is consistentwith the firm’s risk management goals and policies. • Maintain Oversight of risk management function to avoid “surprises” and keep policies in line with the firm’s overall strategies and objectives.

8. Some Relevant Questions • Former SEC Chairman, Richard Breeden, has suggested a few important questions that senior managers/board directors should know the answers to: • Do we know what our risks are? • Do we know what our positions are, right now? • How effective are our controls? • How much does our compensation system encourage perverse behavior? • Who is responsible for making sure we know what we’re doing?