TREASURY RISKS

TREASURY RISKS

1. Interest rate risk2. Foreign exchange risk3. Credit risk4. Commodity risk5. Operational risk6. Liquidity risk7. Other risks

INTEREST RATE RISK

1. Absolute interest rate risk2. Yield curve risk3. Reinvestment or refunding risk4. Embedded options risk

• Absolute interest rate risk– It arises from exposure to a directional (up or

down) change in interest rates

Yield Curve Risk

• Arises from changes in the relationship between ST and LT interest rates

• Usual shape of yield curve is upward sloping• Steepening or flattening or becoming

downward sloping changes the relationship• The change in shape changes the interest rate

differential b/w ST and LT maturities• It impacts borrowing and lending decisions

and therefore profitability

Foreign Exchange Risk

• Transaction Risk• Translation Risk• Strategic Risk

Forex – Transaction Risk

• Arises from transactions reported in the income statement of a company

• Result of purchases/payments in Forex• Inventories, royalties, license fees, etc• Sales in forex

Forex – Translation Risk

• It arises when assets, liabilities or profits are translated from the operating currency into a reporting currency

• For example the reporting currency of a parent company

Translation Risk - ExampleUS $ in millions

UK Pound Sterling@ 1.60 in millions

UK Pound Sterling @ 1.50 in millions

Gross Assets

1,000 625 667

Liabilities 250 156 167

Net Assets

750 469 500

Net Profit

150 97 103

Credit Risk

• Default risk• Counter party risk• Sovereign or country risk• Concentration risk• Legal risk– Arises from a possibility that a counter party is not

legally permitted to enter into transactions such as derivatives transactions

Commodity Risk

• Commodity price risk• Commodity quantity risk• Issues– Quality– Delivery – Location– Transportation– Spoilage– Shortages, storability

Operational Risk

• Human Errors and Frauds• Processes and procedural risk– Eg. Use of inadequate controls – Sarbanes-Oxley act in USA

• Technology and systems risk– Weakness in technology and systems provide

opportunities for errors, failures, lost data and fraud

Liquidity Risk

• The ability of a firm to maintain adequate liquidity through Wrk. Cap. Mgt.

• Firm’s capacity to meet its ST obligations• Ability to buy securities• Ability to sell securities • Ability to close out contracts; trading/hedging• The less liquid a market, the more costly and

difficult to undertake transactions in the mkt.

Other Risks

• Basis risk• Reputation risk• Equity price risk• Systemic risk– Failure of a major financial institution could

trigger a domino effect– Can also arise from technological failure or a

major disaster

Risk Measurement• Two approaches for risk management– Day to day or Tactical standpoint– High level or Strategic view

• It is necessary to have the capability to monitor risk from both stand points

• Risk management requires both quantitative and qualitative analysis

• However it cannot be reduced to a simple – Checklist, a mechanical process or a number

Risk Measurement• Risk assessment is a two part process

1. Assessment of likely gain or loss from changes in market rates or prices

2. Assessment of probability of the changes

Sensitivity

• Calculate net exposure taking into account various positions of the organization

• Example– Exposure to foreign currency– Track all assets, liabilities, expenses and revenues

in a foreign currency– Study fluctuations when exchange rate changes– GAP Analysis

Scenario Analysis

• Also called “ What – If – Aanlysis • Its assesses potential loss by analyzing the

value of an instrument or a portfolio under different scenarios

• One factor scenarios such as interest rates• Multifactor scenarios such as changes in

interest rates as well as changes in foreign exchange rates

Scenario Analysis

• Assess performance of a portfolio of bonds• Portfolio performance might be assessed

under differing differing yield curves – Parallel shift with rising interest rates– Parallel shift with declining interest rates– Steepening of the yield curve– Flattening of the yield curve– Scenario with an inversion to part or all of the

yield curve

Stress Testing

• Assessment of how exposure might perform under more extreme conditions

• It may involve changing one or more variables using major historical price changes

• If test shows unmanageable potential losses• Strategies can be formulated to deal with

them• Proper preparation is the key

Value at Risk

• The most commonly used measure of market risk

• It is a systematic methodology to estimate the potential financial loss for a given period of time

• It is based on statistical estimates of probability at a pre-determined confidence interval

Value at Risk

• An estimate of the probability of a loss being greater than or less than a particular $ amount as a result of market fluctuations

• It is commonly used for portfolios of assets or for exposures

Credit Risk Measurement

• Assessment of probability of counter party defaulting on its financial obligation

• Exposure at counter party default• Loss given counter party default which

considers recovery of amounts that reduces the loss otherwise resulting from default

• Counter party ratings (credit ratings)

Credit Risk Measurement

• Notional Exposure– Notional or contractual or nominal amounts

outstanding sometimes cited as amounts at risk– In certain derivatives transactions, less than

notional amount may be at risk– Full contractual amount is potentially at risk

during settlement

• Aggregate Exposure

Replacement Cost

• The cost to replicate a transaction at current market prices

• Assuming no settlement failures if the derivatives counterparty defaulted on its obligations

Operational Risk – Defined by BIS 2003• Internal Fraud• External Fraud• Employment Practices• Workplace Safety• Clients• Products• Business Practices• Damage to Physical Assets• Business Disruption & System Failures

Operational Risk Measurement

• It results from an organization’s exposure to people, processes and systems

• Such risk management attempts to reduce probability of loss resulting from frauds or errors

• Operational risk databases are being used to measure and manage operational risk

Operational Risk

• Potential for operational risk include– Number of deviations from policy or stated

procedures– Comments and notes from internal or external

audits– Levels of staff turnover– Volatility of earnings– Unusual complaints from customers and vendors– Volume of derivatives trade

Operational Risk – Example TSE 2005• During the initial public offering of J-Com on

December 8, 2005, an employee at Mizuho Securities Co., Ltd. mistakenly typed an order to sell 610,000 shares at 1 yen, instead of an order to sell 1 share at 610,000 yen.

• Mizuho failed to catch the error; the Tokyo Stock Exchange initially blocked attempts to cancel the order, resulting in a net loss of 347 million US dollars to be shared between the exchange and Mizuho.

Operational Risk – Example TSE 2005• Both companies are now trying to deal with

their troubles: lack of error checking, lack of safeguards, lack of reliability, lack of transparency, lack of testing, loss of confidence, and loss of profits.

• On 11 December, the TSE acknowledged that its system was at fault in the Mizuho trade. On 21 December, Takuo Tsurushima, chief executive of the TSE, and two other senior executives resigned over the Mizuho affair.