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TREASURY RISKS

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									TREASURY RISKS
              TREASURY RISKS
1.   Interest rate risk
2.   Foreign exchange risk
3.   Credit risk
4.   Commodity risk
5.   Operational risk
6.   Liquidity risk
7.   Other risks
            INTEREST RATE RISK
1.   Absolute interest rate risk
2.   Yield curve risk
3.   Reinvestment or refunding risk
4.   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 - Example
           US $ in    UK Pound    UK Pound
           millions   Sterling@   Sterling @
                      1.60 in     1.50 in
                      millions    millions
Gross      1,000      625         667
Assets
Liabilities 250       156         167
Net        750        469         500
Assets
Net        150        97          103
Profit
                    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.

								
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