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A Survey on Risk Management

and Usage of Derivatives by

Non-Financial Italian Firms

7/08



A Survey on Risk Management

and Usage of Derivatives by

Non-Financial Italian Firms

by Gordon M. BodnarCostanza Consolandi

Giampaolo Gabbi

Ameeta Jaiswal-Dale

n. 7/08Milan, July 2008

Copyright

Carefin, Universit Bocconi



CAREFIN WORKING PAPER I

INDEX

Abstract

1. INTRODUCTION 1

2. A REVIEW OF PREVIOUS SURVEYS 2

3. SURVEY METHODOLOGY AND SAMPLE 11

4. DERIVATIVES OR INSURANCE INSTRUMENTS USAGE AND

USAGE INTENSITY BY 1999 13

5. DERIVATIVES USAGE CONDITIONAL ON SIZE AND ACTIVITY 16

6. EXPECTED BENEFITS FROM RISK MANAGEMENT ACTIVITY 18

7. CONCERNS ABOUT DERIVATIVES USAGE 20

8. THE RISK MANAGEMENT ACTIVITY IS BEEN INFLUENCED

BY IAS NEW ACCOUNTING RULES? 22

9. INTEREST RATE RISK MANAGEMENT31

10. ENERGY AND COMMODITY DERIVATIVES USAGE 32

11. OPERATIONAL RISK MANAGEMENT 34

12. CONCLUSIONS 36

References 38

ANNEX 1 PREVIOUS SURVEYS 39

ANNEX 2 SURVEY OF RISK MANAGEMENT BYITALIAN NON-FINANCIAL FIRMS 41


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CAREFIN WORKING PAPER II

Abstract

This paper presents a survey on the risk management function and the usage of hedging

instruments by Italian non-financial firms. The objective is to measure how firms manage the

following risks: Exchange-foreign, Interest rate, Energetic, Commodity, Equity, Counter-party,

Operational, Country. The study aims at providing descriptive evidence with respect to several

questions that are raised in the literature and that are finalized to find out if the firms hedge their

exposure or potential exposure, which particular financial risks are managed, how widespread is

the derivatives usage, the choice of which derivatives are used for which purposes, the risk

management policy implementation, the performance measurement and reporting structure.

In Italy accurate disclosure of derivatives usage in financial statements does virtually not

exist. As a result, relatively little is known about the patterns of use and of firms attitudes and

policies with respect to derivative use. To fill the information gap, this survey documents theusage of derivatives by non-financial large companies.

The outcomes of the survey, conducted both for listed and non-listed firms, suggest that

Italian firms are less likely to use derivatives than US firms. The percentage of firms using

derivatives or insurance instruments has not changed noticeably since 1999 (the beginning of the

euro period). The use of derivatives is more significant among large firms in every risk typology

and, in the area of commodity and equity risk management, large firms are the unique size group

that uses these instruments in its management activity. The fact that large firms are more likely to

use derivatives is suggestive of an economies-to-scale argument for derivatives use.

According to Italian risk managers the low intensity in derivative use cannot be explained by

(i) concerns about external perception of derivative/insurance use; (ii) costs of risk managementgreater than benefits; (iii) expected price to move in firms favour; (iv) shareholders expectations

to manage risk; (v) uncertainty of timing and/or size.

The reasons to explain the limited practice in derivative markets are as follows:

1. Insufficient exposure to risk area to warrant management;2. Exposure more effectively managed by other means:3. Difficulties in monitoring/measuring contract effectiveness.


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CAREFIN WORKING PAPER 1

1.

INTRODUCTION

Financial risks management is a composite activity. Some players managed risks by veryconventional operations but very often this is not a tractable and financially feasible solution.More sophisticated tools are derivatives, able to reduce the total risk in the system (Smith, 1995),or transferring to economic agents that are prepared to bear these risks.

As to the reasons why firms should or should not hedge, the discussion is still going on andmost depends on firms risk appetite, but on the consciousness as well.

Fenn et al. (1997) and Smith (1995) provide a comprehensive overview of the valid reasonsto hedge and their analysis among the US firms. Gczy et al. (1997) and Nance et al. (1993)argued in their study that the traditional arguments by Smith and Stulz (1985) to motivatehedging (such as managerial risk aversion, the expected costs of financial distress or concavity infirm value due to convexity in tax liabilities) are necessary but by no means sufficient conditions.

According to many researchers, one factor that justifies the hedging activity is represented bythe capital market imperfections even if many others issues also affect the companys decision onthe derivatives usage (such as the presence of a sufficiently large risk exposure and costs ofimplementing).

We can see from the literature a number of valid reasons why firms should hedge (forexample, this activity has the purpose to maximize shareholder value).

Quantitative information about corporate derivatives usage, however, can be obtained eitherfrom surveys or from financial statement but especially in the European continent the information

that financial statements provide is often extremely limited in the scope. A notable exception, aspresented above, is provided by Bodnar and Gebhardt (1998) who provide a comparativeevidence among German and US firms.

In Italy, moreover, accurate disclosure of derivatives usage in financial statements doesvirtually not exist. As a result, relatively little is known about the patterns of use and of firmsattitudes and policies with respect to derivative use.

To fill the existing gap, this survey documents the use of derivatives by non-financial largefirms operating in Italy.

The study aims at providing descriptive evidence with respect to several questions that areraised in the literature and that are finalized to find out if the firms hedge their exposure or

potential exposure, which particular financial risks are managed, how widespread is thederivatives usage, the choice of which derivatives are used for which purposes, the riskmanagement policy implementation, the performance measurement and reporting structure.


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2.

A REVIEW OF PREVIOUS SURVEYS

In the last three decades, a number of studies examined risk management practices, focusingon management behaviour in presence of a potential risk and showing a detailed explanationabout the financial instruments adopted in management activity.

Some studies described the use of derivatives by non-financial firms [see Hakkarainen et al.,(1997); Berkman and Bradbury (1996); Judge (1995); Alkebck and Hagelin (1996); Bodnar andGebhardt (1997); Bodnar et al. (1998); Pramborg (2000); El-Masry (2001)], yet, another group ofresearchers investigated the determinants of corporate hedging policies by financial firms [Fatemiand Fooladi (2005)] or by public companies listed [Berkman et al. (1996)]. Some studies, finally,analysed both financial and non-financial firms, listed and not listed [see Block and Gallagher

(1986); Dolde (1993); Anand and Kaushik (2004); Servaes and Tufano (2005)]1.Block and Gallagher (1986) examined the corporate use of derivatives in interest rate

exposure hedging activity in United States, after in October of 1979 the Federal Reserve hadchanged its policy, increasing the interest rates volatility, creating an incentive for hedgingactivity of interest rate exposure. Other incentives for hedging included the predominance offloating rates on the short-term side of the credit markets and the ever-increasing debt burden ofU.S. corporations. In spite of these factors, the use of hedging through interest rate futures andoptions resulted in a relatively immature state.

They used questionnaires to gather data from all Fortune 500 companies, receiving answersfrom 193 of them, with a rate of response of 38,6%. Results showed that approximately one outof five firms used interest rate futures and options to hedge the interest rate exposure, with a

higher usage degree by larger firms and firms in traditionally commodity-oriented industries. Thetwo most frequently used hedging instruments were Treasury bill futures and Eurodollar futures.Interest rate futures seemed to enjoy a greater popularity than interest rate options. Among therespondents, futures were perceived as being advantageous in terms of cost and efficiency inhedging and options were seen as providing less risk exposure and fewer administrativeproblems.

Out of the 193 respondents to the survey, approximately eighty percent were currently non-users of interest rate futures and options. The primary reasons given for non-utilization were topmanagement resistance, lack of knowledge, restriction on upside potential, the expense involvedand legal and accounting obstacles.

The survey conducted by Dolde (1993) on Fortune 500 companies (244 of which completedthe questionnaire, with a 48,8% response rate)2 reported that large companies diverged greatly inthe scope and sophistication of their approach to risk management, despite bigger firms could

1 See Annex 1.

2 The main differences between Dolde (1993) and Block and Gallagher (1986) questionnaires were represented by the parameters

utilized by Dolde in defining his own survey. In fact, the researcher studied not only corporate activity in interest rate riskmanagement but the foreign rate risk hedging activity, too. Furthermore, Dolde reported information about the use of swaps, futures,forwards and options.


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profit of a greater portfolio diversification, making the risk exposure less urgent. Smallcompanies reputed the costs of management of financial risks as a negative voice of their budget,ignoring the benefits that could come down from such activity. Another important explanatoryvariable of the risk management approach was found in the view of market directions by thetreasurer.

Of the 244 Fortune 500 companies that responded to the survey, over 85% reported swaps,forwards, futures, or options in managing financial risk.

Hakkarainen et al. (1997) exhibited the results of a survey conducted in 1994 on interest raterisk management in the top 100 largest Finnish non-financial firms3. The data for this studyconsisted of answers to a questionnaire and financial statement data. The questionnaire wasmailed in 1994 to 100 firms4, 84 participated. The Finnish survey found that most commonfeatures in the interest rate risk management approach were avoidance of risks andminimisation/maximization of interest expenses/income, revealing risk aversion to be the

prevailing attitude in most firms. A very interesting finding was that over 40% of the respondingfirms had not made an effort to estimate the interest rate exposure of any item. However, theevidence suggested that large firms employ duration and gap analyses more frequently than smallfirms.

Regarding hedging instruments, the answers show that, first of all, Finnish firms used theInterest Rate Swap (IRS), the second common instrument was the Forward Rate Agreement(FRA), and third, the Over The Counter (OTC) options.

Berkman and Bradbury (1996) presented an empirical study on the determinants of corporateuse financial derivatives in New Zealand5, extending previous research findings by includingother explanatory variables that they expected to influence the corporate hedging decision.Specifically, they tested the managerial risk-aversion hypothesis, the relation between the use of

derivatives and the level of foreign activities and the need to coordinate investing and financingpolicies. The authors sampled all firms listed on the New Zealand stock Exchange excludingforeign firms6 and firms in the financial services sector. Of the remaining 116, 55 firms (48%)held financial instruments at balance date. None of the firms in the sample indicate that derivativefinancial instruments were used for speculative purposes. According to risk management theory,data showed that corporate derivative use increase with leverage, size, the existence of tax losses,the proportion of share held by directors, and the payout ratio, and decrease with interestcoverage and liquidity.

3 Finnish firms have been faced with greatly fluctuations interest rates since the deregulations of the money market bean in the latterhalf of the 1980s. due to efforts to curb domestic demand and support the external value of the money, money interest rate were higharound the turn of the decade. After the flotation of the money, interest rates fell substantially. Long-term interest rates rose in 1994

as a result of the world-wide bond rally while there was a downward trend in short-term rates, owing to low inflation and amplemoney market liquidity resulting from efforts of the central bank to stimulate growth.4 The authors considered like discriminatory factor the turnover value of 1992.

5 Also in New Zealand the use of financial derivatives has grown dramatically since the deregulation of New Zealand financial

markets in 1984. Over the period June 1987 to June 1994, the notional amount of swaps held by financial institutions increased from$2,350 million to $39,710 million; options and futures increased from $6,436million to $29,106 million; and forward contractsincreased from $53,710 million to $143,076 million.

6Because they were not subject to the same financial disclosure rules as local firms.


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The study by Judge (1995) introduces a different way to define hedging: it recognised thatfirms can manage their risks in several ways and therefore firms that did not use derivativesmight hedge through alternative means.

Like other previous studies, this paper empirically investigated the determinants of corporatehedging using a sample of large firms. The sample was selected from the 1995 FTSE500 whichlisted the 500 largest UK companies quoted on the London Stock Exchange, ranking a companyby its market capitalisation. The sample was restricted to non-financial firms7, so that the finalsample consisted of 441 non-financial firms.

Results showed that 78% of the 186 societies exhaustively completing the questionnairerevealed to use derivatives as a tool of risk coverage, while the figure inferred by the annualreport was slightly lower (67%).

Besides, from the data we can deduce that, mainly, the implicit assumption is that derivativeswere used for hedging rather than speculation and that the great enterprises used more commonly

these products than small enterprises.Jalilvand (1999) and Jalilvand and Switzer (2000) analysed the outcomes of a survey

conducted in 1996 on a sample of Canadian listed non-financial companies. Jalilvand (1999)showed that scale, operational efficiency, and the level of the integration of treasury activities areimportant determinants for identifying Canadian and international users of derivatives. Thematurity debt was also longer for users of derivatives, suggesting that derivatives may be used toreduce the adverse effect of wealth transfers from shareholders and bondholders. The authorfound no evidence that managerial risk aversion and ownership concentration influence corporateuse of derivatives in Canada.

From the comparison between the Canadian, American and New Zealand societies, the authorunderlined that all of them were governed by similar influences and that they differed only in therole that every of them attributed to the alternatives forms of coverage, as the liquidity, thedividend payout and the use of different debt instruments.

Jalilvand and Switzer (2000) provided evidence of important similarities and differences inderivatives usage between Canadian, U.S, and European risk managers8, revealing that the use ofderivatives products was more widespread in Canada than in United States and ContinentalEurope. Most firms were found to have written risk management policies, but did not benchmarktheir treasury performance. Moreover, Canadian risk managers were less inclined than theirEuropean and American counterparts to take positions based on their views on the market.

Berkman et al. (1997) describe derivatives usage of a sample of New Zealand (NZ) firms9compared with the results of previous US surveys10. The main issue the authors addressed was

7 Firms from the financial services sector were excluded from the sample because their risk management activities include bothhedging and speculative transactions.8 See Bodnar, Hayt, Marston and Smithson (1995), Downie, McMillan, and Nosal (1995), Bodnar, Hayt, and Marston (1996), Dolde

(1993).9 They sent questionnaires to 124 public companies listed on the New Zealand Stock Exchange (NZSE) and received a total of 79useable responses, which represents a response rate of 63.7%.10 The comparison was done with recent surveys by Bodnar, Hayt, and Marston (1996); Bodnar, Hayt, Marston and Smithson(1995); and Phillips (1995) presented descriptive evidence on the use of derivatives by US non-financial firms.


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whether derivatives use is a phenomenon primarily limited to the sophisticated and liquid USfinancial markets. The focus on a small economy such as NZ provides an interesting perspective.The objectives of financial risk management are very similar for both NZ and the US.

In the same way, the data showed, surprisingly, that New Zealand companies used morefrequently and in greater measure the derivatives contracts in comparison to the Americanenterprises: 53.1%, of respondents affirmed that they used derivatives. This result compared to26.5% (1995) and 17.5% (1996) of the respondents in the US surveys underline with evidencethe conclusions of the authors.

The data showed that in NZ, 100% of the firms with market value of equity greater than $250million used derivatives, compared to 65% in the US. Of the firms with market value lower than$50 million. 36% of NZ firms used derivatives, compared lo 12% of US firms. The surveyshowed, finally, that the most used financial tools, mainly to hedge foreign and interest rate risks,and largely from the great enterprises, were the Forward Rate Agreement followed by the Interest

Rate Swaps.Alkebck and Niclas (1999) provided survey evidence on the use of derivatives among

Swedish non-financial Firms11. The results were directly compared with those presented inBodnar et al. (1995, 1996), without controlling for differences in size and industry classification.The Swedish survey found that lack of knowledge about derivatives within the firm is the mainconcern for Swedish corporations.

The questionnaire12 was mailed to the financial directors of all non-financial firms listed onthe Stockholm Stock Exchange. The 213 usable responses have given the survey a reasonable76,53% response rate13.

In accordance with Bodnar et al. (1995, 1996) and Berkman et al. (1997) they found thatfirms derivative hedging activity was primarily concentrated in foreign exchange and interestrate exposure. In addition, swaps were the most commonly used instruments for interest rateexposure, whereas swaps, futures and OTC forwards were the dominating instruments for foreignexchange exposure. The frequent use of futures to manage foreign exchange exposure was incontrast with Bodnar et al. (1995, 1996) and in particular Berkman et al. (1997).

Loderer and Pichler (2000) surveyed the currency risk management practices of Swissindustrial corporations. The aim of their research was twofold: first, to examine if the non-financial societies quantified their risk profile and, second, to analyze if and how they managedthe currency risk that, again, would have been able to threaten their economy14.

11 Although derivatives have a long history, the past two decades have witnessed a substantial increase in the variety andcomplexity of derivatives. The vast number of derivatives available has increased the possibility for firms to reduce their financialexposure. However the same instruments have also increased the possibility for risk taking by firms. Thus, the task of overseeing

financial activities within firms has become more complicated. Consequently, knowledge about firms derivative practices hasincreased in importance to shareholders, creditors, regulators, and other interested parties. in Per Alkebck and Niclas Hagelin,1999. This study was undertaken in response to this problem.

12 It was very concise consisting in 13 questions.13 The response rate was ampler than the American studies (26.5% in 1995 and 17.5% in 1996) but in line with that New Zealand(63.7% in 1997).14 The leitmotiv of their investigation is to seek in a recent past: Between 1978 and 1996, the Swiss franc experienced dramaticswings in relation to major currencies such as the U.S. dollar, the Italian lira , and the British pound. Comparing highest and lowest


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The questionnaire was sent to all 165 firms listed in the Zurich Stock Exchange (ZSE) in1996 except for banks and insurance companies. For comparison purposes, the same survey wassent to 165 non-traded firms randomly selected from the 1994 and 199515. The main conclusionof Loderer and Pichler was that industrial firms did not have the abilities to define the risk of thevalues profile of their company.

De Ceuster et al. (2000) sent a questionnaire to 334 large corporations operating in Belgium.This population consisted of 221 Coordination Centres and 123 largest firms ranked byturnover16. The global response rate was 21.9% that was in line with the previous analysis.

The data shows that 65.7% of the 73 respondents reported that they used derivatives, 22%never used them and 12.3% gave up using them. The authors, besides, tried to determine thereasons why some of them did not use these financial tools or had stopped doing it. The resultsshowed that 50% of non-users considered like principal motivation the policy restrictionsimposed upon the treasurers by the board of directors. Other often-cited reasons are the risk of

the products, the significance of the exposure and the existence of other hedging alternatives.When the authors asked about their intentions of using derivatives in the futures, only one fifth ofnon-user said that they were willing to consider derivatives for hedging purposes in the futures.

This study, also, reported data on large typologies of covered risks (interest rate andcommodity risk) and the principal derivatives instruments used by companies (Forwards RateAgreement followed by Interest Rate Swaps, by options OTC and, finally, by structuredcontracts).

Bodnar and Gebhardt (1999) provided comparative evidence of German vis--vis US firms.The questionnaire was mailed to 368 firms and 126 of them answered (whit an answers rate34.24%)17. Bodnar and Gebhardt limited their analysis to three typologies of derivativesinstruments,to hedge foreign exchange, interest rate and commodity price risk.

Results showed that German firms are more likely to use derivatives than US firms, with 78percent of German firms using derivatives compared to 57 percent of US firms.

As pointed up by Bodnar and Gebhardt, the explanation of this substantial difference lies inthe politics of control and monitoring that were substantially more urgent for German enterprisesin comparison to the most permissive Americans rules18.

exchange rate levels, the U.S. dollar depreciated by 60% vis vis the Swiss franc, the Italian lira by 70%, and the British pound by

62%. Moreover, although not as high as those observed in the equity markets, annual currency rate volatility of the U.S. dollar, e.g.,has exceeded 12%. in Loderer and Pichler, 2000.

15 The results show a greater adhesion from listed companies with a 36.36% answer rate in opposition to the 21.82% of the notrated, but, in average, they conducted to 29.09% answer rate, in line with the previous investigations.16 Also in this study the turnover was used as a selection criterion, and were ranked the firms with an average turnover of 26.2billion BEF.

17 To create a group of US firms that are structurally comparable to the German respondents from which the responses to thequestionnaires be compared, the authors dropped 150 US respondents with sales below $133.3 million. In addition, to improve thematching on the industry structure side, they eliminated three US companies in the gold mining industry, as there are no comparable

companies in Germany.18 Another valid explanation is the risks exposure of the international operations. In the specific one, the German societies mainlyoperated through international operations that, from a side, had the advantage to define an inside monetary market ampler but, from

the other side, determined a greater exposure to potential risks that was managed with a greater employment of derivatives products.


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The general pattern of usage across industry and size suggest that the general tendency to usederivatives was driven by economic issues such as operational activities and firm characteristics.While firms in both countries indicated that they used derivatives mostly for risk management,differences appeared in the primary goal of using derivatives, with German firms focusing moreon managing accounting results whereas US firms focusing more on managing cash flows.

Mallin et al. (2001) put on an analysis related to the use of derivatives instruments, to thekind of covered risks and to the methodologies adopted for their evaluation comparing data withthose in Bodnar et al (1995). The questionnaire was mailed to 800 UK non-financial firms thatwere randomly selected from Hemmington Scotts Corporate Register, which lists companies onthe London Stock Exchange19.

The data showed that of the 231 respondents, 62.1% reported using at least one derivativeinstrument. As can be seen from answers, the analysis of the usage of derivatives related tocompany size as measured by turnover shows a significant relationship with larger companies

using derivatives instruments more likely than smaller companiesThese responses supported previous surveys in that large firms but, in comparison to Bodnar

et al. (1995) they showed lower derivatives usage among smaller firms.

The authors asked firms to indicate the reasons they did not use derivatives. Predominantly,the most important reason was the lack of significant exposure to financial risk, followed by thecost of derivatives program, the third most frequently chosen factor was the fact that the exposurecan be managed by other means.

The mostly utilized derivatives instruments by UK non-financial firms were the FRA andOTC options.

Bodnar et al. (1998) report the results of the third of a series of surveys20 on financial risk

management practice and derivatives use by non-financial corporations in United States. Dealingwith a comparison among the three Warthon surveys, so to define the evolution of derivativesusage in the time.

The analysed sample consisted of the original randomly 2000 publicly traded firms used in1994 plus the remaining 154 non-financial Fortune 500 firms added in 199521.

The obtained response rate was of 20.7%.

The very notable results show that the derivatives users rate was in continuous growthpassing from 35% in 1994, to 41% in 1995, up to 50% in survey in matter.

The authors were interested in determining whether there was any change in the intensity ofusage among firms that use derivatives; of derivatives users, 42% indicated that their usage had

increased over previous year, compared to just 13% who indicated a decrease. These response, insubstance, wanted to underline as there was a greater proportion of risk managers that consideredmore important the benefits than the consequential costs from the use of these products.

19 Some 231 replies were received from sample of 800, a response rate of 28.9%, which is slightly more than the Bodnar et al.response rate of 26.5%.

20 The first and the second surveys were conducted in 1994 and 1995, respectively.

21 Specifically, due to mergers, buyouts and bankruptcies since 1994, the sample consisted of 1928 firms.


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Another characteristics of American firms were figured out by the analysis of the firm size;the most greater derivatives users resulted the large firms (83%) followed by the medium-sizedfirms (45%) and, finally, from the small ones (12%).

A good response rate was obtained from the analysis conduced by Fatemi and Glaum (2000)in Germany. It was mailed to 153 great non-financial firms listed on the Frankfurt StockExchange22, and it received responses from 71 of theses firms (answers rate of 46.41%).

The researchers carried out an analysis that could consider all the typologies of risks theGerman enterprises should have managed and that could describe the derivatives usage by theirrisks managers.

The questionnaire was designed to elicit the respondents assessments of how different goalsrank in terms of their importance for risk management; ensuring the survival of the firmsturned out the most important goal and increasing the market value of firms ranked as thesecond most important goal23. Other remarkable purposes, in order of importance, that were

indicated in the answers were: to increase the profitability, to reduce cash flow volatility and toreduce earnings volatility.

The answers analysis relative to financial instruments usage show some very interestingdata. The majority of respondent, 88%, indicated that they used derivatives instruments. This is amuch higher proportion than reported by Bodnar et al (1998) for US firms either in their 1995survey (41%) or in their 1998 survey (50%). It is also higher than the 78% rate that Bodnar andGebhardt (1998) reported for their sample of German firms24.

Among the users, 75% used only the so-called plain vanilla instruments (mainly ForwardsRate Agreement and Interest Rate Swaps) and the remaining 25% utilized more complexinstruments.

Finally, we can deduce that 89% among players made use of these contracts only for hedgingpurpose of the industrials or financials or operatives risks and only 11% did it for speculativepurpose.

Bodnar et al (2003) study derivative usage in the Netherlands They gathered data from aquestionnaire sent to 167 non-financial listed firms producing 84 usable responses (responses rateof 50.3%).

The results show that 60% of Dutch firms used derivatives versus 44% of US; the differenceamong the two countries decreases with the dimensional increase of the societies25.

22 With a minimum 1997 sales volume of DM 400 million, as discriminatory criteria.23 The dominance of the survival goal over the market value goal can be seen as a manifestation of the German socio-politicalsystem. Within this system, the firms is often regarded as an entity, in and of itself, which is held accountable to a broad set ofconstituents. Shareholders are one of these, albeit (arguable) the most important one. Therefore, it should not come as a surprise that

the survival of the firms ranks as the most important goals for the corporate risk management. in Fatemi and Glaum, 2000.24 As a matter of fact, the sample used by Bodnar and Gebhardt also considered the small enterprises; this, considering the evidenceshown by the results of the previews surveys, that the employment of the derivatives is directly proportional to the dimensions of the

societies, makes the results of the two German surveys very closed.25 In fact, the data show that the 42% of the small Dutch enterprises were derivatives users against only 12% of those American; forthe medium sizes societies the difference is of 11 percentages points (46% American firms against 57% Dutch firms) while the great

enterprises showed a similar use rate (82% United States against 88% the Netherlands).


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Moreover, risks managers hedging activity is mainly devoted to the minimization of the cashflow volatility. The comparative analysis on financial instruments mainly employed by risksmanagers shows that for the monetary risk hedge activity in both Countries OTC Forwardscontract are preferred the, followed by options OTC and, in contrast to American societies, anyDutch firm used the futures contracts; while, the interest rate risks were covered resorting to theIRSs.

Pramborg (2005) compares derivative usage in Sweden and Korea. The sample wasconstituted of 250 Swedish firms listed on the Swedish Stock Exchange and 387 Korean firmslisted on the Korean Stock Exchange26. The response rate was different between the twocountries (42.2% Swedish and 15.5% Korean sample), with a total response rate of 26%.

The questionnaire contained questions regarding: the respondents exposure to foreignexchange rates and whether the respondent firm hedges; the respondents use of foreign currencyderivatives (types of instruments, frequency of use, concerns); the respondents use of other

foreign exchange risk management methods (foreign debt, internal techniques); and therespondents control and reporting procedures (decision making process, evaluation).

The results suggest both similarities and divergences between the two countries. The mostpeculiar difference was the purpose of risks managers: Korean risk managers were more likely tofocus on minimizing fluctuations of cash flows, while Swedish risk managers favouredminimizing fluctuations of earnings or protecting the appearance of the balance sheet.

Swedish firms were characterized by higher levels of FX exposure for revenues, costs, andnet assets as compared to Korean firms; also, the percentage of firms that indicated no exposureis similar in both countries. However, the proportion of Korean firms that used derivatives wassignificantly lower. This result, as the author explains, may be due to the higher fixed costsincurred by Korean firms initiating derivatives programs. These higher costs could result from

the relative immaturity of Korean derivatives markets and, perhaps more importantly, fromKorean authorities heavy regulation of OTC derivatives use.

Finally, another resemblance is the large proportion of firms in both countries used a profit-based approach to evaluate the risk management function.

El-Masry (2003) gathered data from a questionnaire sent to 401 non- financial firms listed onLondon Stock Exchange and 173 among them completed the questionnaire (response rate was43.14%). In this study, corporate treasurers were asked a number of questions relating to thefollowing areas: derivatives use, currency derivatives, interest rate derivatives, options contracts,and control and reporting policy.

The main results can be considered as a confirmation of some analyses previously effected in

UK27

. Out of 173 respondents who returned the questionnaires, 116 (67%) gave details they wereusing derivatives; in the size, usage was heaviest among large firms at 56.25%, it dropped to 33%for medium-sized firms and to 10.0% for small firms28; in the ownership dimension, derivatives

26Utilities were excluded in both countries.

27See Judge (1995) e Mallin, Ow-Yong and Reynolds (1997).

28 Large-sized firms are so much more likely to use derivatives because of the economies-to-scale argument for derivative use.


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usage was greatest among public companies at 56.25% and the derivatives use rate dropped to6.25% for private firms.

Among the reasons for which some firms did not use derivatives instruments, data indicatethat 50% of firms did not use derivatives because their exposures were not significant; also, themost important reasons were: concerns about disclosures of derivatives activity required underFASB rules; concerns about the perceptions of derivatives use by investors, regulators, analystsor the public; and costs of establishing and maintaining derivatives programmes exceed theexpected benefits. This is followed by: exposures which are more effectively managed by othermeans such as risk diversification or risk shifting arrangements, lack of knowledge aboutderivatives and then difficulty pricing and valuing derivatives.

Results reveal that centralised risk management activities were overwhelmingly mostcommon and that, for firms using derivatives, foreign exchange (FX) risk was the risk mostcommonly managed with derivatives. Interest rate (IR) risk was the next most commonly

managed risk.The data, finally show that the most important reason for using hedging with derivatives was

to manage the volatility in cash flows at 37% of the responding firms.

Anand and Kaushik (2007) analyse the derivatives usage in India, focusing on foreignexchange risk management. The questionnaire was mailed to 640 companies, which werecommon across two most widely used Indian stock market indices29 having foreign exchangeexposure. 55 responses were received leading to a response rate of 8.59%.

Answers show that 70.4% of the respondents firms explained that they used foreign exchangerisk management plan or policy or programme because risk managers had acquired the awarenessthat these activities not only mitigate the risks but also allow the reduction of the volatility inprofits and in the cost of the capital, therefore increasing, the value of the firms. Also, the firmswith high debt ratio were more likely to use foreign currency derivatives.

The authors, finally, classified the finalities to which the risks managers tended in theiractivity: the major objective of using derivatives is hedging the risk for arbitrage purpose andprice discovery; the speculation as objective of using foreign currency derivative is the leastpreferred option.

An important survey, about the risk management policy adopted by corporations wasconducted by Tufano and Servaes (2007). It deals with a global study that does not considerone or more specific risks neither a particular country in which to define the investigation; thesurvey, in fact, has been structured to consider a plurality of risks, then brought back to threemacro-sample: the market risks30, the commercial risks31 and the external event risks32. The

29 Namely S&P CNX 500 and BSE 500 firms.30 These risks relate to price movements in financial markets and include interest rate risk, foreign exchange risk and commodityprice risk as well as possible pension fund shortfalls. They can usually be managed through the use of financial derivatives.

31 These are risks intrinsic to the firm and, to a certain extent, under its control. They include failures of internal processes as well as

actions by competitors. They are typically difficult to manage, especially with financial contracts.32 These risks are not necessarily firm specific, and relate to non-market external events, such as natural catastrophes or changes intax or regulatory policies. Events like litigation are a blend of these risks and commercial risks. External event risks can sometimes bemanaged using insurance contracts.


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sample contains the Deutsche Banks corporate customers in 39 different countries33. Theanalysis of the answers by the 334 societies define many important results. Data show that 73%of the interviews firms used one of the typologies of scenery analysis (as the stress test), from36% to 45% utilized the measures at-Risk (id est: the VaR, the CaR and the EaR), and only 6%employed an analysis considering the shareholders value, for example the shareholder valueanalysis (SVA).

The answers about the instruments utilized in risk management activity display that the mostcommon instruments were: the assurance tools, the derivatives instruments to hedge the foreignrisk and the interest rate risk34.

3.

SURVEY METHODOLOGY AND SAMPLE

Our study fully traces the survey conducted by Bodnar in 1998 among US non financialfirms35 and was conducted from September 2007 to January 2008. It deals with a webquestionnaire36 containing 40 questions about risk management activity and the derivativesinstruments usage.

It used a data processing guarantor that no connection was made between answers and thename of the company. The anonymity of responding firms was guaranteed.

Our sample selection had to deal with the low number of non financial listed firms in Italy.Therefore, we included also non listed (non financial) firms. The selection criteria included all

the firms with a minimum sales revenue value of Euro 500 million realized in 2006 included inthe AIDA database.

As defined above, the sample was restricted to non-financial firms. The sample consists of526 non-financial firms, 123 listed on Italian Stock Market and 403 unlisted; moreover, we hadto consider that, among these, 62 companies answered that they were not interested to theanalysis, so that the final sample size was of 464 firms. The survey started in September 2007with telephone calls to the CFOs or Risk managers of firms included in the sample, in order toobtain the personal e-mail address where to send all the information on the survey. One monthafter the first e-mail, we followed up with another e-mail to confirm the delivery of thequestionnaire and the firms participation.

We obtained response from 86 firms: 14 listed (with a response rate of 11.38%.) and 72 non

listed (response rate of 33%). The global response rate of 18.53% which is in line with the

33 The sample contains listed and not listed companies; particularly: conglomerates, industrial firms and utilities.34 They were chosen by 83%, 82% and 79% of interviews, respectively.35 The original version of the 1997 questionnaire was updated with questions on Energetic/Commodity Risk, Credit Risk, Geo-Political Risk and Operational risk and customized for Italy.

36See the questionnaire in Annex 3.


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response rates37 reported by M. Bodnar et al. (1998) (20,70%), Jalilvand (1999) (28,10%),Jalilvand and Switzer (2000) (28,10%), De Ceuster et al (2000) (21,86%), Mallin et al. (2001)(28,88%), Pramborg (2005) (25,59%) and Fatemi and Fooladi (2006) (21%).

Thanks to the general questions, we had the possibility to sort the surveyed firms by industryand by size. Insofar, of the 86 firms that have exhaustively completed the questionnaire, 38 arefrom the manufacturing sector; 12 from the primary- product sectors; and 10 from retail andwholesale trade. Table 1, provides a profile of the sample firms.

Table 1

Firms by Industry

Industry

No.Firms % sample

Manufacturing 38 44.2%

Transportation/Energy 12 14.0%

Retail/Wholesale 10 11.6%

Mining/Construction 6 7.0%

Communications/Media 4 4.7%

Tech (Software/Biotech) 4 4.7%

Service/Consulting 2 2.3%

Other 10 11.6%

Banking/Finance/Insurance 0 0.0%

In terms of head offices, we received answers primarily from north-west Italy (37%) followedby centre and north-east with the same percentage (26%) and, at last, the south and islands withonly 2%. In term of size, we divided our sample in sub-groups according to sales revenues;sample distribution by firm size is shown in Table 2.

37 A notable exception is Hakkarainen at al. (1997), who obtained a response rate of over 80% for their sample of 100 largestFinnish companies.


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Table 2

Firms by sales revenues.

Sales Revenue

Number of answers Percentage

Less than Euro 24 million 0 0.0%

Euro 25-99 million 7 8.1%

Euro 100-499 million 16 18.6%

Euro 500-999 million 33 38.4%

Euro 1-4.9 billion 27 31.4%

Over Euro 5 billion 3 3.5%

4.

DERIVATIVES OR INSURANCE INSTRUMENTS USAGE AND USAGE

INTENSITY BY 1999

The first question was designed to know if firms manage their risks, and, if so, whichcategory of instruments (derivatives and/or insurance contracts) they utilize and, at least, todetermine whether there was any change in their usage intensity of these instruments after theEuro introduction.

We considered eight typologies of risks, as shown in figure 1: foreign-exchange risk, interest

rate risk, energetic risk, commodity risk, equity risk, counter-party risk, operational risk andcountry risk.

The figure reveals that the most commonly managed risk by risk managers is the foreign-exchange risk: more than 67% of the respondents answered to do it. Interest rate risk is the nextcommonly managed risk with 60.47% followed by the counter-party risk with 30.23%.


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Figure 1

Management and Used Instruments

0,00%0,00%

20,93%

4,65%2,33%

0,00%

18,60%2,33%

13,95%

20,93%20,93%4,65%

25,58%23,26%

4,65%

30,23%0,00%

25,58%

60,47%58,14%

9,30%

67,44%55,81%

6,98%

0,00% 10,00% 20,00% 30,00% 40,00% 50,00% 60,00% 70,00%

Exchange-foreign

Interest rate

Counter-party

Commodity

Energetic

Country

Equity

Operational

Management

Derivatives tools

Insurance tools

We were also interested in the percentage of firms that use derivatives to manage risk in each

of these eight classes to compare it to the percentage of firms that, opposite, use insuranceinstruments.

As the figure shows, the derivatives tools are mainly utilized to manage the foreign-exchangerisk by 56% of respondents; interest rate risk derivatives instruments are used by 58%; energeticrisk and commodity risk derivatives are utilized by 21% and 23% of the respondents,respectively.

On the other hand, 26% of risk managers mainly utilize the insurance instruments to manage

the counter-party risk; the operational risk are manage by assurance tools by 21% of them; thethird mainly hedged risk typology by insurance instruments is the country risk by 21% of therespondents.

As underlined by the data, the use of derivative tools is more widespread among the Italianfirms compared to the use of insurance tools but this is only for some typologies of risk (forexample, in foreign-exchange risk management there is a difference of 49%). On the contrary,considering the counter-party risk or the operational risk the tendency is reversed: data show thatderivatives instruments are not quite used.

It should be noted that unlike of exchange risk such as interest rate risk, which are likely to befaced by all firms, same firms will not directly face others categories of risk, as equity, country,


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counter-party and operational risk because of the nature of their activity. Consequently, the usageof derivatives in these classes, will be even higher than the numbers displayed in the figure.

Whilst the evidence suggests that the percentage of firms using derivatives or insuranceinstruments has not changed noticeably, we were also interested in determining whether therewas any change in the intensity of usage among the firms after the Euro introduction. To considerthis, firms were asked to indicate the usage intensity of their derivatives and insurance tools by1999 choosing among high, medium or low level.

Table 3

Usage Intensity by 1999

Usage intensity by 1999

Insurance tools Derivatives tools

Risks High Medium Low High Medium Low

Exchange-foreign 2,33% 2,33% 11,28% 23,26% 18,60% 23,26%

Interest rate 0,00% 2,33% 13,95% 4,65% 25,58% 27,91%

Energetic 0,00% 2,33% 4,65% 2,33% 4,65% 13,95%

Commodity 2,33% 0,00% 4,65% 9,30% 4,65% 13,95%

Equity 0,00% 0,00% 2,33% 0,00% 0,00% 4,65%

Counter-party 11,28% 6,98% 4,65% 0,00% 0,00% 2,33%

Operational 6,98% 9,30% 2,33% 0,00% 0,00% 2,33%

Country 11,28% 2,33% 4,65% 0,00% 0,00% 2,33%

Table 3 displays the response to this question for each type of risk. The first evidence that wecan underline is the fact that, for each risk category derivatives users indicated a low intensity ofusage more than a high intensity; opposite, this tendency is not confirmed by insuranceinstruments (in counter-party risk or country risk management the respondents report a higherpercentage of high intensity of insurance instruments usage than percentage of low intensity).

Overall, these responses suggest that a significant proportion of economic operators is notfinding derivatives helpful enough to increase so much their usage and, moreover, that maybethis situation is mainly defined by the low knowledge of derivative instruments among the Italianfirms.

5.

DERIVATIVES USAGE CONDITIONAL ON SIZE AND ACTIVITY

We were also interested to define the relation between the size group and the industrial sectorwith the derivatives usage. We set up a cross-tab between the sales revenue value and the datafrom derivatives usage and between the industrial sectors and the data from derivatives usage. Asa result we obtained Figure 2 and Table 4.


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According to firms size, Figure 2 displays that derivatives instruments usage is heaviestamong large firms in every risk typologies and, in the area of commodity and equity riskmanagement, large firms are the unique size group that uses these instruments in its managementactivity.

About this analysis there is an exception, the derivatives instruments are used only bymedium-size firms in country risk management activity. Moreover, as shown by Figure 2 thepercentage of the small-sized firms that use the derivatives instruments is rather insignificantcompared to medium and large firms percentage, and more data report a derivatives usagesminimum value only in the exchange foreign and interest rate risk management.

The fact that large firms are more likely to use derivatives is suggestive of an economies-to-scale argument for derivatives use, with large firms better able to bear the fixed cost ofderivatives use compared to medium and small sized-firms.

Figure 2

Derivatives Usage Response Rates By Size

9,09%

45,45%45,45%

4,55%

45,45%

50%

44,44%

55,55%

100% 100% 100%

0,00%

10,00%

20,00%

30,00%

40,00%

50,00%

60,00%

70,00%

80,00%

90,00%

100,00%

Exchange-

foreign

Interest rate Energetic Commodity Equity Country

Derivatives Tools

Derivatives Usage Response Rates By Size

Small

Medium

Large

Table 4 describes the percentage of derivatives usage by each specific industry: the

derivatives usage is greater among manufacturing firms; the percentage that we can see incurrency, interest rate and commodity risk is greater than the percentage of the others sectors; thisis not confirmed in energetic and equity risk where they result in second position behind theprimary product producers as principals derivatives instruments users.

Therefore, these data describe that the derivatives instruments are mostly used bymanufacturing firms and primary product producers.


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Theory and the evidence from others countries, remark that futures exchanges were originallyestablished to help manage commodity risks, so that our data confirm previous results.

The fact that the manufacturing firms belong to one of industrial sectors that use mostlyderivatives instruments in their management activity is likely driven by foreign currencyexposure arising from foreign operations or exporting and importing.

Table 4

Cross-tab Derivatives Instruments & Industry

Derivatives tools

Industry ExchangeForeign

Interest rate Energetic Commodity Equity Country

Retail/

Wholesale

4,55% 13,64% - 10% - -

Mining/Construction

4,55% 9,09% - 10% - -

Manufacturing 54,55% 45,45% 33,33% 50% - 100%

Transportation/Energy

18,18% 18,18% 66,67% 20% 100% -

Communications/Media

4,55% - - - - -

Tech 9,09% 9,09% - - - -Banking/Finance/Insurance

- - - - - -

Service/Consulting

- - - - - -

Other 4,55% 4,55% - 10% - -

6.

EXPECTED BENEFITS FROM RISK MANAGEMENT ACTIVITY

The second question was to understand which were the most important benefits that managersexpected from their risk management activity. Therefore, we asked firms to indicate theimportance of nine listed goals on a increasing scale, among very important important non

important dont know (Table 5).The most important purposes of risk managers appear to be Avoids large losses from

unexpected price movements /events (VaR) and Shareholders expect us to manage risk.Reduces operating cash flow volatility ranks as the third most important goal (20,93%). Otherimportant goals, in order of importance are Increases reported earnings predictability (9.3%)and Improve the firms credit ratings (spread out) and Reduces the firms cost of equity (bothwith a score of 6.98%).


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Table 5

Degree of Importance of same Potential Benefits of Financial Risk Management Strategy

Potential Benefits of Financial Risk

Management Strategy

Very

Important

Important Not

Important

Do Not

Know

Avoids large losses from unexpectedprice movements /events (VaR)

32,56% 44,19% 16,28% 6,98%

Shareholders expect us to manage risk 32,56% 30,23% 25,58% 11,63%

Reduces operating cash flow volatility 20,93% 58,14% 16,28% 4,65%

Increases reported earnings predictability 18,60% 44,19% 30,23% 6,98%

Increases the firms expected future cash flows 9,30% 30,23% 46,51% 13,95%

Improve the firms credit ratings (spread out) 6,98% 23,26% 51,16% 18,60%

Reduces the firms cost of equity 6,98% 32,56% 53,49% 6,98%

Decreases volatility of share price 4,65% 30,23% 53,49% 11,63%

Other 2,33% 2,33% 4,65% 90,70%

Consistent with these results, when asked to choose only one goal among the list presented inprevious question as the most important benefit, the majority (39.53%) choose to avoid largelosses from unexpected price movements /events (VaR).


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Figure 3

Most Important Benefit expected from Financial Risk Management

2,56%

2,56%

2,56%

7,69%

12,82%

28,21%

43,59%

0% 5% 10%15%

20%25%

30%35%

40%45%

50%

VaR

Reduces operating cash flow volatility

Increases reported earnings predictability

Shareholders expect us to manage risk

Decreases volatility of share price

Increases the firms expected future cash flow s

Reduces the f irms cos t of equity

Improve the firms credit ratings

Other

Most important benefit

7.

CONCERNS ABOUT DERIVATIVES USAGE

The use of derivatives in todays market involves many issues. Question 3a askedrespondents to indicate their degree of concern about a series of issues regarding the use ofderivatives. These issues include: accounting treatment, credit risk, market risk (unexpectedchanges in prices of derivatives), monitoring and evaluating hedging results, reaction by analystsand investors, disclosure requirements, and secondary market liquidity. For each issue, we askedfirms to indicate the degree of concern, among a high, moderate, or low level, or indicate that theissue is not a concern to them. Firms were also given the option of listing any other issues ofgreat concern to them regarding derivatives use.

Given to propensity of a majority of firms to indicate a moderate level of concern and thenot concern with many issues, Figure 4 indicates the percentage of firms by degree of concernfor the seven issues.


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Figure 4

Concerns Regarding Derivatives

7,50%

7,69%30,77%

7,69%

10,26%28,21%

14,63%

26,83%

17,07%31,71%

25,64%35,90%

37,50%22,50%

0,00% 5,00% 10,00% 15,00% 20,00% 25,00% 30,00% 35,00% 40,00%

Monitoring and evaluating hedge results

Market risk

Credit risk

Accounting treatment

Disclosure requirements

Other

Secondary market liquidity

Reaction by analysts or investors

Degree of Concerns about some Issues

High Low Monitoring and evaluating hedging results is the issue causing the most concern among

derivatives users, with 34.88% of the firms indicating a high concern, 20.93% low and 13% noconcern with this issue.

Market risk, defined as unforeseen changes in the market value of derivative position, is thesecond issue underlined by firms, with 23.26% of the firms indicating a high degree of concernsbut, opposite, more than 32% of the surveyed firms indicate a low degree of concerns.

This is followed closely by credit risk with 16.28% of the firms indicating a high degree ofconcerns but there are more than 30 points of percentage of the respondent indicate a low degreeof concerns.

The remaining issues has significantly more firms indicating little or no concern as comparedto high concern.

We also asked firms to indicate their most serious concern for the items listed above.Surprisingly, market risk is revealed to be the most serious concern (30.23%), followed bymonitoring and evaluating hedging results with 18.6% of the firms ranking this as their mostserious concern.


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8.

THE RISK MANAGEMENT ACTIVITY IS BEEN INFLUENCED BY IAS

NEW ACCOUNTING RULES?

Questions 5a asks respondents to describe which kind of impact have produced the newaccounting rules (International Accounting Standard n 32 and n 39) on risk managementactivity.

From 2005 the rated companies had to observe the international accounting principles IFRS(International Financial Reporting Standard) in the editing and in the presentation of the businessbudgets. Objective of the IFRSs, along with harmonization of formalities of budget editing, is tobring nearer the book value to the current value of the firm.

The application of the principles IAS 32 and IAS 39, that introduce particularly a newclassification of the financial tools, involves also meaningful innovations in the accountingmanagement of the operations of coverage effected through the use of derivatives instruments.

Particularly, the IAS 39 focuses on the evaluation of the financial tools specifying the field ofuse of the fair value as evaluation criterion. Moreover, in this principle is detailed when mustadopt the fair value, when the historical cost or the amortized cost as evaluation criterion. Thisprinciple also specifies when it is necessary to consider the variation of the fair value to balancesheet and when to revenue account.

The international accounting principles forecast the finding of the derivatives to the contractstipulations date in the system of general accounting and the visualization in the asset of thebalance sheet.

Figure 5 displays our results. More than 68% of the firms answered that the new accountingrules did not have effect on their risk management activity. The remaining 31.71% declared thatthe new accounting rules have as consequence a reduction of derivatives usage and a changein the types of instruments used defined by 12.2% of the respondents in both cases, or a changein the timing of hedging transactions with 6.98%.


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Figure 5

Impact of the IASs New Rules

The most likely Impact of the IASs New Rules on Derivatives Accounting

68,29%

12,20%

12,20%

7,32%

No eff ect on derivatives use or risk management strategy A reduction in the use of derivatives

A change in the types of instruments used Alter the timing of hedging transac tions

FOREX Risk - Currency Exposure

Respect to the currency risk, the first question presents an hypothetical situation, in order tounderstand the weight of the financial operations in Euro currency compared to the operations inanother currency. Specifically, the defined hypothetical situation had the goal to individualize theimpact of a Euros devaluation of 10 points percentages, in comparison to the foreign currencies,

on the firms risk value. Almost 50% of the sample has answered that they will not have anyfluctuation from this hypothetical situation and a low percentage of the respondents define apossible fluctuation of their risk value greater than 5%.

The outcomes deduced by this question confirm that the majority of respondents manage theforeign exchange exposure (as shown above, in the question 1) and that, therefore, thishypothetical situation has some marginal effects on the firms risk value.

Particularly, to learn about the exposure of the analyzed sample, question 7 asks firms toindicate their percentage of total revenues and costs in foreign currency.


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As Table 6 shows a reasonable percentage of firms reports either no foreign currencyrevenue (27.50%) or no foreign currency cost (15.38%); another reasonable percentage of therespondents have answered that their foreign currency revenue or cost are less than 10%, 27,50%and 46.15% respectively;on the other hand, more than 40% of the firms report foreign currencyrevenues to be more than 10% of total revenue, while 35% of the firms report foreign currencycosts to be more than 10% of total expenses. So, many firms in the sample have significantforeign exposure.

Table 6

Percentage of Consolidated Revenues and Costs Based in Foreign Currencies

Percentage based in foreign

currencies

% of consolidated revenues % of consolidated costs

0% 27,50% 15,38%5-10% 27,50% 46,15%

10-20% 12,50% 20,51%

20-30% 12,50% 5,13%

30-40% 5,00% 2,56%

40-50% 7,50% 7,69%

50-60% 5,00% 0,00%

60%+ 2,50% 2,56%

FOREX Risk - Transactions in Derivatives Markets and Typology of RiskManagement Activity

Not much is known about the extent to which firms hedge their various exposures, so weasked firms to indicate the percentage of perceived exposure, across various categories ofcurrency exposure, that they typically hedge. These categories of currency exposure are: foreignrepatriations, contractual commitments, anticipated transactions within one year, anticipatedtransactions beyond one year, operating/competitive exposure and translation of foreignaccounting statements.

Table 7 reports the percentage of firms that have responded in each of the five proportion ofexposure hedge for each of seven different categories of exposure. The table displays that withthe exception of three types of exposure, Contractual commitments Anticipated transactionswithin one year - Competitive exposure, the majority of firms hedge less than 25% of theirperceived exposure.

However, in the cases of these three types of exposure, the firms percentage that defined tohedge more than 75% of the total exposure is not so high, 10.71%, 14.29% and 22.22%respectively. Thus, partial hedging appears to be normal practice for these firms.

This evidence is confirmed, and partly justified, by the last column of the table; it expressesthe percentage of the companies that answered not to be exposed to that specific category of


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exposure. As we can see, the firms percentage that answered not to be exposed is 25% or morefor each specific category of exposure.

Table 7

Percentage of Foreign Currency Exposures Typically Hedged

Percentage of Firms Responding in the Following Ranges for the Proportion of Exposure

Hedge

Classes of

exposure

0% 1-25% 26-50% 51-75% 76-100% N/A

Foreignrepatriations(e.g., dividends,royalties)

42,86% 7,14% 0,00% 3,57% 3,57% 42,86%

Contractualcommitments

35,71% 25,00% 0,00% 3,57% 10,71% 25,00%

Anticipatedtransactionswithin one year

14,29% 25,00% 14,29% 7,14% 14,29% 25,00%

Anticipatedtransactions inmore than oneyear

34,62% 19,23% 3,85% 3,85% 3,85% 34,62%

Operating/Competitiveexposure

7,41% 33,33% 11,11% 11,11% 22,22% 14,81%

Translation of

foreignsubsidiaryfinancialstatements

29,63% 14,81% 3,70% 3,70% 0,00% 48,15%

Other 31,25% 0,00% 0,00% 0,00% 0,00% 68,75%

Question 9 asked companies to point out the implementation nearest to their reality among 5possible choices. (see the annex 2 page 42).

In more than 50% of questionnaires, no answer was given to this question: data reported inFigure 6 refers to the percentage of respondents to the questionnaire.

The mainly used technique results by each exposure separately as they arise within each line

of business / division with 44.44% of the respondents that have chosen this technique, followedby pooling/netting across classes of exposures and pooling across lines of business / divisionswith more than 33%.


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Figure 6

Typology of Foreign Exchange Risk Management Activity

Typologies of Implemantation of FX Risk Management

Activity

44,44%

33,33%

11,11%

11,11%

By each exposure separately as they arise w ithin each line of business / division

By pooling/netting across classes of exposures and pooling across lines of business / divisions

By netting w ithin separate classes of exposure w ithin each line of business / division

By each separate class of net exposures pooling across many lines of business / divisions

FOREX Risk - Instruments in Foreign-Currency Risk Management

Our analysis is not only finalized to illustrate the typologies of managed risks in themanagement activity but, also, to determinate the mostly used financial instruments in thisactivity.

Question 10 asked managers to point out the used tools among ten instruments that we havelisted in the same question.

Figure 7 illustrates the financial instruments list and, for each of them, the percentage of therespondents that point out in what measure that specific tool is used in foreign exchange riskmanagement.


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Figure 7

Instruments Usage in foreign-exchange risk management.

2,33%

4,65%

4,65%

9,30%

9,30%

18,60%

18,60%

23,26%

25,58%

55,81%

0,00% 10,00% 20,00% 30,00% 40,00% 50,00% 60,00%

Forward contracts

OTC options

Currency sw aps

Money market contracts and FOREX positions

Option combinations (e.g., collars, straddles)

Futures contracts

Foreign currency debt financing

Non deliverable forwards

Excange trated options

Other

Instruments Used in FX Risk Management

As the figure shows, the most commonly used instruments are the Forward contracts (55.81%). Far from these, there are OTC options, followed closely by currency swaps indicated by23.26% of the respondents as the most commonly used instruments.

We were also interested to know the opinion of the Italian risk managers about the three mostimportant instruments among these listed in previous question; we asked firms to list, in order ofimportance among three of these instruments. The results confirm the same tools defined before,or rather: the most important used instruments is Forward contract, the second most important is

OTC option and the third most important is currency swap.


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FOREX Risk - Benchmark for Evaluating Foreign-Currency Risk

Management

One question focused on the benchmarks that firms use to evaluate the risk managementprocess. For currency risk management, we asked which benchmarks they use to evaluateforeign-currency risk management over the budget/planning period. Figure 8 displays theresponses. Out of the firms surveyed, 37.50% indicated that they did not have a benchmark forevaluating the foreign-currency risk management process. Of the remaining responding firms, themost common benchmark was the use of the forward rates available at the beginning of thebudget/planning period. Particularly, of the firms with some benchmarking, 26.32% use a pre-defined percentage-hedge benchmark (25%) and 20% of them use the forward rates.

15% of the companies of our survey indicated to use the spot rates available at the beginningof the period and the exchange rates available at the previous period. These approaches arequestionable on theoretical grounds as the current spot rates and the previous exchange rates donot incorporate any market expectations of currency movements over the period nor do they offerrates at which any risk could actually be laid off.

Out of the firms with some forms of benchmark, 10% use the forecast variance analysis andanother 10% use the forecasted variance R (risk adjusted basis)

Finally, 5% of the responding firms indicated the use of some other forms of benchmark.Despite the fact that some of these ideas have more value than others, it is worrying that morethan 37% of the firms do not have a well specified benchmark for evaluating whether theircurrency risk management process is providing any useful service to the firm.


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Figure 8

Benchmark usage in evaluating FX risk management strategy

5,00%

10,00%

10,00%

15,00%

15,00%

20,00%

25,00%

37,50%

0,00% 5,00% 10,00% 15,00% 20,00% 25,00% 30,00% 35,00% 40,00%

Our firm does not use a benchmark

Of those w ith a benchmark:

A pre-defined percentage-hedged benchmark

Beginning of period forw ard rates

Beginning of period spot rates

Exchange rates from previous period (quarter or year)

Forecast variance analysis

Forecasted variance R risk adjusted basis

Other

Benchmark's Usage

FOREX Risk - Influences from the Market View and from Euro Currency as

Foreign Exchange Reserve

Financial managers typically found difficult to avoid letting their own view of the currencymarket affect their risk-management activities. Therefore, we asked firms to indicate thefrequency with which their market views cause them to alter the timing or size of their hedges orto actively take a position in the market using derivatives. The responses to this question arepresented in Figure 9.


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Figure 9

Market View of Exchange Rates Influences.

7,14%

42,86%

3,70%

33,33%

33,33%

0,00%

5,00%

10,00%

15,00%20,00%

25,00%

30,00%

35,00%

40,00%

45,00%

50,00%

Alter the timing of

hedges

Alter the s ize of hedges Actively take positions

Frequently Sometimes In response to the first part of the question, 7.14% of the firms indicated that their market

view on exchange rates frequently altered the timing of hedge and 3.70% of them indicated thattheir market view on exchange rates frequently altered the size of hedge that they entered into.A large number of firms occasionally incorporate their market view into their hedging decision,with of the firms sometimes altering the timing of their hedges and one third of the firmssometimes altering the size of their hedges.

Without entering the debate about what constitutes a hedge and what constitutes speculation,it is apparent that a majority of respondents sometimes takes into account their opinion aboutmarket conditions when choosing a risk-management strategy, but there is a significantpercentage of firms who answered they never took into account their opinion about marketconditions when choosing a risk-management strategy (more than 50% for each of potentialactivity).

About the third part of the question, the figure shows that only 33.7% among the respondentstakes sometimes position based on a market view of the exchange rate.

A particular characteristic about the Italian firms, that comes out from this survey, is obtainedwhen we asked if the fact that the Euro currency became a foreign exchange reserve could havesame effects on firms coverage level of the exchange risk. The answers define that more than75% of the firms consider this event without consequences on their coverage level of theexchange risk.


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9.

INTEREST RATE RISK MANAGEMENT

Interest rate risk is the second category of risk managed by Italian non-financial firms. Table8 displays the frequency of usage of IR derivative activity across four common uses. Italian firmsseem to be more frequent users of IR derivatives for purposes of swapping from floating rate debtpayments to fixed rate debt payments and fixing a rate on new debt. Overall, the most commonused interest rate derivative is the swap from floating to fixed rate debt: 42% of firms use thisinstrument at least sometimes. This result is consistent with the results of Bodnar and Gebhardt(1999) for German and US companies.

Table 8

Frequency of transactions in the interest rate derivatives market (%)

Transactions in IR Derivative

Markets

Frequently Sometimes Rarely N/A

Swap from fixed rate to floatingrate debt

0.00 7.89 21.05 71.05

Swap from floating rate to fixedrate debt

15.79 26.32 23.68 34.21

Fix in advance the rate (spread) onnew debt

15.79 13.16 21.05 50.00

Reduce costs or lock-in rates forfuture financing

8.11 24.32 24.32 43.24

These results are strengthened once we compared the different financial tools used by Italianfirms: interest rate swaps are the most popular instruments with more than 50% of respondentsranking them as the most important instrument. Interesting to notice is the relative high use ofoption combinations (22%).

Table 9

Preference among interest rate derivative instruments

Forward rate agreements 9.30%

Interest rate futures -Interest rate swaps 55.81%

Interest rate swaptions 6.98%

OTC IR options 2.33%

Exchange-traded options 2.33%

Option combinations 20.93%

Alter the timing of debts 4.65%

Other 2.33%


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When we asked companies to describe the benchmark they adopt for evaluating the IR riskmanagement of debt portfolio nearly 40% doesnt use any benchmark. Among those who usebenchmarks, realized cost of funds relative to a market index (e.g. Libor) is the benchmark usedby nearly 60% of firms respondents (see Table 10).

Table 10

Benchmarks used for evaluating IR risk management of debt portfolio

Benchmark %

Our firm does not use a benchmark for the debt portfolio 38.24%

Of those with a benchmark:Realized cost of funds relative to a portfolio

with a specified ratio of fixed to floating rate debt

14.29%

Realized cost of funds relative to a market index (e.g. Libor) 57.14%Realized cost of funds relative to a portfolio with a specified duration 14.29%The volatility of interest expense relative to a specified portfolio 9.52%Other benchmark 4.76%Total 100%

10.

ENERGY AND COMMODITY DERIVATIVES USAGE

Only recently, energy and commodity risk have become a component of the risk managementfunction for non financial firms (Bodnar and Gebhardt, 1999). This evidence conflicts against thedistinguished volatility of commodity indexes, even higher than currencies. Among commodities,energy ones, electricity in particular, show an unpredictability rate which suggests the hypothesisthat an essential loss component depends upon these factors.

Nevertheless, when we asked how many different types of energy and commodity priceexposures the firm would evaluate and manage, only 21% answered 1 or more than 1 (table 11).


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Table 11

How many different types of energy price and commodity price exposures does your firm

evaluate/manage? (%)

0 1 2+ N/A

Energy (fuel/electricity): 23.26% 6.98% 13.95% 55.81%Commodities (agricultural/non-oil primaryproducts)

25.58% 11.63% 9.30% 53.49%

The only difference among energy and commodity risk is the number of price exposuresmeasured by risk managers: 14% are worried of 2 or more than energy risk factors, only 9.3% areworried of 2 or more than commodity risk factors, such as agricultural and non-oil primaryproducts.

Then we compared the financial tools used by firms. Most of firms have a preference forover-the-counter ones, such as swaps, forwards and OTC Options with their combinations (table12).

Table 12

Percentage of used instruments in energy/commodity risk management

Forward contracts 18.60%Debt contracts with embedded options 0.00%Futures contracts 16.28%Non deliverable forwards 2.33%

OTC Options 11.63%Exchange traded options 2.33%Option combinations 9.30%Swaps 16.28%Foreign currency debt financing 0.00%Other 0.00%

Plain vanilla and non deliverable forwards are used by 20.93% of our sample; swaps by16.28% and OTC options by 11.63% and option combinations (such as collars and straddles) by9.3%.

The questionnaire asked to find out the most important derivative to hedge the commodity

risk. If compared the Italy situation with those analysed in Germany and the USA in 1999 showsthe following features (figure 10):

- in Italy the most important derivative contract is supposed to be the futures (28.9%), the samefor Germany but lower than the US firms (40,4%);

- forwards and futures appear to be equally weighted, while in Germany forwards arepredominant (55.5%). This depends on the lower importance of regulated markets in Europethan USA;

- roughly 20-25% of firms prefer swaps in the USA and Italy, only 11% in Germany;


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- options only for a little number of firms is considered the first instrument to hedge risks. InItaly structured options are the most important for 14 firms out of 100: this could depend onthe different period of the surveys and the recent development of option combinations inbanks portfolios.

Figure 10

Preference over Energy and Commodity Derivative Instruments (the most important hedgeinstrument) in Italy (2007), Germany and USA (1999)

0.0 10.0 20.0 30.0 40.0 50.0 60.0

Forward contracts

Futures contracts

OTC Options

Exchange options

Option combinations

Swaps Italy

Germany

USA

11.

OPERATIONAL RISK MANAGEMENT

According to Basel 2, operational risk is defined as the risk of loss resulting from inadequate

or failed internal processes, people and systems or from external events. It includes internal andexternal fraud, Employment Practices and Workplace Safety, Clients, Products & BusinessPractices, Damage to Physical Assets, Business disruption and system failures, Execution,Delivery & Process Management.

In Italy, 37,2% of our sample evaluates operational risks for any of the processes.

We asked whether decision to introduce metrics in order to measure the risk was correlated tothe blackout event that occurred in 2003. That episode was a serious power outage that affectedall of Italy for 9 hours on 28 September 2003. It was the largest blackout in the series of


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blackouts in 2003, affecting a total of 56 million people. It was also the most serious blackout inItaly in 20 years.

Actually, only 17,2% of firms asserts that more importance was devoted to the sensitivity tooperational risk management. All the others did not change the approach and about 10% reducedthe investments in ORM.

Figure 12

The change in the role of operational risk, after the black out in Italy of September 2003

6,90%

3,45%

17,24%

72,41%

0,00%

10,00%

20,00%

30,00%

40,00%

50,00%

60,00%

70,00%

80,00%

much less

emphasis

less emphasis about the same more emphasis much more

emphasis

In order to measure the operational risk, most of the firms appear to be vague when asked the

kind of database they use. Table 13 shows firms answers: only 14% asserts the usage of specificdatabase or a simulation model.


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Table 13

Which kind of dataset was used to estimate the operational losses?

Event Type Internal External Simulation No answer

High Frequency Low Impact 2,33% 6,98% 4,65% 86,05%

Low Frequency High Impact 4,65% 4,65% 4,65% 86,05%

The operational risk management appears to be very conventional (table 14). 94,1% of firmshedges operational losses with traditional insurance contracts, while alternative risk transfer toolsare unknown.

Only the case of catastrophe options are used by firms.

Table 14Contracts used to manage the operational risk

Contract Use (%)

Insurance contracts 94,12%First loss to happen put 0,00%Cat bond 0,00%Insurance Alternative Risk Transfer 0,00%Operational Risk Swap 0,00%Cat options 5,88%

12.

CONCLUSIONS

This paper presents a survey on the risk management function and the usage of hedginginstruments by non-financial firms. The outcomes of the survey, conducted both for listed andnon-listed firms, suggest that Italian firms are less likely to use derivatives than US firms.

The percentage of firms using derivatives or insurance instruments has not changednoticeably since 1999 (that is, the beginning of the euro period). The use of derivatives is moresignificant among large firms in every risk typology and, in the area of commodity and equityrisk management, large firms are the unique size group that uses these instruments in itsmanagement activity. The fact that large firms are more likely to use derivatives is suggestive ofan economies-to-scale argument for derivatives use.

The reasons to explain the limited practice in derivative markets are as follows:

- Insufficient exposure to risk area to warrant management;

- Exposure more effectively managed by other means;

- Difficulties in monitoring/measuring contract effectiveness.


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Table 15 shows the distribution of these factors among different risks.

Table 15

The most important factor(s) for not using derivatives

FX IR EN CM EQ CR GP OR

Insufficient exposure to riskarea to warrant management

6.95 - 9.30 11.60 13.93 9.27 13.93 6.95

Exposure more effectivelymanaged by other means

2.30 - 4.65 2.30 2.30 2.30 2.30 4.65

Difficulties inmonitoring/measuring contracteffectiveness

- 2.30 - - - - - -

According to Italian risk managers no other reasons should explain the intensity in derivativeuse, such as, (i) concerns about external perception of derivative/insurance use; (ii) costs of riskmanagement greater than benefits; (iii) expected price to move in firms favour; (iv) shareholdersexpectations to manage risk; (v) uncertainty of timing and/or size.


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