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Key Financial Risks by Warren Edwardes,

Chief Executive of Delphi Risk Management Limited.

"Key financial risks"  Autumn 2000, Issue 8 Global Trading, London link

This article forms the basis of chapter 4 of the book by Warren Edwardes

key financial instruments. understanding and innovating in the world of derivatives - warren edwardes "Key Financial Instruments: understanding and innovating in the world of derivatives" 4 February 2000 Financial Times Prentice Hall ISBN 0273 63300 7 London  link

"50 Ways to lose your money"

Warren Edwardes is CEO of Delphi Risk Management, the London-based financial product creativity, communication and control consultancy.

Warren was previously on the board of Charterhouse Bank and has worked in the treasury divisions of Barclays Bank, British Gas and Midland Bank. He first researched into what were later to be called "derivatives" in 1975 and was part of the team that executed one of the world's first currency swaps in 1981. Since then he has devised and transacted numerous structures that form part of the history of derivatives. Warren can be contacted via

Derivatives were derived either to hedge or to eliminate risks or to do the opposite – take risks. In fact hedge funds such as Princeton Global Management, the fund which ceased trading in September 1999 amid accusations of fraud, quite do anything but hedge. They deliberately take risks through futures markets to generate higher returns. So what sort of risks are usually managed by using financial derivatives? This chapter examines the main economic and business risks facing an organisation and against which immunisation is required.

Currency risk management

Ignoring the "derivatives" used by the ancient Egyptians, Greeks, Romans and the Dutch tulip dealers often quoted in histories of derivatives, modern financial risk management begins following the collapse of the era of fixed exchange rates and the gold standard. The process accelerated with the global liberalisation of foreign exchange controls which in the UK occurred with Margaret Thatcher’s election at the end of the 1970’s. The consequent floating and volatile exchange rates in the UK meant that corporate treasurers had to actively manage the foreign exchange exposure resulting from international trade. The financial instrument used was the forward foreign exchange contract which was an agreement to exchange a certain principal amount of one currency for a certain amount of another currency at an agreed exchange rate and on a specified future date.

There are three main types of foreign exchange or currency exposure – Transaction Exposure, Translation Exposure and Economic Exposure.

Transaction Exposure

Currency transaction exposure arises out of income and expenditure denominated in a foreign currency. It is the risk of depreciation of a foreign currency receivable or the risk of appreciation of a foreign currency payable measured in terms of the home or accounting currency of an entity.

Consider a British car company, Rover which exports cars to Spain. The cars are offered for sale in Spanish Pesetas which since 1 January 1999 are mere denominations of the Euro. In this case, transaction exposure is the risk that the Euros received through the sale of Rover cars in Spain could depreciate against Sterling and thus wipe out the required profit margin or even lead to a loss.

Translation Exposure

Transaction exposure arises out of cash flows. Currency transaction exposure is a function of the revaluation of assets and liabilities. Translation exposure therefore is the risk of depreciation of a foreign currency denominated asset or the appreciation of a foreign currency denominated liability.

Rover is a British company but it is wholly owned by Germany’s BMW. Rover’s balance sheet is in Sterling (or so I believe) whilst BMW has a balance sheet denominated in Deutsche Marks which are like Spanish Pesetas now denominations of the Euro. Even if Rover proves to be profitable in Sterling terms, if Sterling depreciates against the Euro then the value of the car company, an asset in BMW’s books, will fall and BMW would occur a translation loss.

Translation exposure is not just a book-keeping statistic. Real exposure materialises leading to real cash losses when a foreign currency denominated subsidiary is sold or a currency loan is repaid on maturity. In the early 1980’s Laker Airways, a small UK airline went into liquidation partly through economic exposure. The company had a substantial LIBOR-linked US Dollar loan raised to pay for new DC10 aircraft. The airline’s year-by-year profitability was dominated by foreign exchange gains as Sterling had appreciated against the US Dollar from GBP/USD 1.50 to GBP/USD 2.40 and so its management was not persuaded by its bankers to hedge the company’s translation exposure. Sterling duly fell back from GBP/USD 2.40 towards GBP/USD 1.50 and the airline not only suffered through higher interest charges in Sterling but also was liable to raise more Sterling to pay off its US Dollar debts.

More recently I was asked for advice by the bursar of an East Asian university on fund raising for a new hospital wing. Foreign exchange borrowing controls were about to be lifted and they said that they were thinking about borrowing in low-cost US Dollars rather at much higher domestic interest rates. US Dollar borrowing may indeed have cost less in the short term but had they executed such a strategy, they would have faced a substantial appreciation in their liability when their currency fell in the Asian economic crisis of late 1997.

Economic Exposure

If Rover hedges its transaction exposure in EU exports through sales of Euros it would lock in the proceeds of its cars in Sterling terms. Say, the Euro appreciates strongly including against Sterling. Because of its hedging activity in the foreign exchange market, Rover would not be in a position to pass on the benefit of lower costs in Euro terms. Perhaps Saab is a close competitor to Rover in Spain. If the Swedish Kronor depreciates against the Euro, Saab could be in a position to reduce its prices in Euros to Euroland and undercut Rover. This is currency economic exposure for Rover. Now if the Swedish Kronor does not depreciate against the Euro, Rover could still suffer economic exposure in its competition with Saab cars. Saab is a subsidiary of General Motors which owns Vauxhall in the UK. General Motors could switch the production of Saab cars from Sweden to Luton in England which following the depreciation of Sterling has become a relatively low cost production base. Recall that Rover has already locked in the value of Euros in sterling terms and cannot take advantage of the higher value of the Euro. This is also economic currency exposure also known as competitive currency exposure.

Because of the appreciation of the Pound versus the Euro, Honda UK is reported to be turning their attention to exporting to the US market instead of the rest of the EU. ("Honda delay blamed on strong Pound" BBC online Business news. 31 October 2000 and "Currency worries force Honda to change plans" Financial Times, 1 November 2000)

The strategy sounds really ingenious but they could be in for a nasty surprise. If production costs of British made cars are now, say, 20 % more than European made cars when sold in Europe, selling to the US or elsewhere does not help. On the same assumption of a 20% Sterling uncompetitiveness versus the Euro, production costs do not change. They are now also exactly 20 % more in the UK than in Euroland for cars sold to the US, Japan, South Africa or South America. There is no refuge from an overvalued currency if the UK produces directly comparable products in a competitive market. Changing models and "strategy quickly if currency conditions change" to the CR-V for the US only makes sense if there is no similar Euroland made product also sold in the US.

Nevertheless, considering purely the foreign exchange exposure angle, it makes sense for the likes of Honda to continue to invest in the UK as a means of long-run currency diversification. It could, of course, hedge itself by paying its employees partly in Euros and organise regular employee shopping trips to France not just to Auchan for beer but also to Ikea for furniture!

Interest rate management

In contrast to the UK and other economies which have a substantial international component to their economies, foreign exchange exposure has been of relatively little importance to US treasurers. On the other hand, interest rate management came to the fore when the then chairman of the Federal Reserve Paul Volcker raised US interest rates from about 5 per cent to 21 per cent and then all the way back down again to 6 per cent in the time span of about a year.

Interest rate exposure is the risk that interest rates will rise leading to a rise in the interest liabilities of borrowers or the risk that interest rates will fall leading to a fall in the interest rate income of floating rate investors. Fixed rate bond investors also have an interest rate exposure as the value of their assets is determined by the present value of the future stream of income from the bonds. As interest rates rise so do the discounting rates used to calculate the present values and therefore the value of their investments fall.

UK mortgage borrowers have traditionally borrowed for house purchase at floating rates but over the past decade fixed rate mortgages have become commonplace. Retail borrowers thereby avoid risk by passing it on to the mortgage banks who use a variety of derivatives products to hedge the risk in the market.

A particular form of interest rate risk is interest rate basis risk. This applies when a borrower raises finance linked to one market but hedges in another market in the same currency. The resultant risk between the two markets is basis risk. An example could be borrowing in the US Commercial paper market and using LIBOR linked derivatives.

Equity risk management

Equity risk refers to the risk that the share price of a firm will rise or fall. It also refers to the possible change in the market value of a basket of shares. The expected return on equities is considerably greater than the expected return on bonds because of the higher risk. In the event of a liquidation, deposit holders and bond holders are paid before equity holders receive anything. Accordingly equity investments are considerably more volatile than bond investments or holding assets ion bank deposits. However, a number of banks have issued deposit structures which include linking to various stock market indices thus introducing broad-based equity market linking with a view to taking advantage of the historical high growth in the equity market. These are hedged using equity derivatives.

Equity risk also applies to firms that plan to issue shares in the market to raise working capital or to release value for the start-up owners. In 1987, the UK government launched the privatisation of BP. But between the announcement of the offer price and the closing of the offer, there was a world wide crash in stock markets – Black Monday intervened.

Commodity and inflation risk management

Commodity risk management has, perhaps been practised even before the advent of financial risk management. There were active futures markets in oil, gold, copper, and a variety of agricultural products well before futures markets in financial risk.

Pension funds, in particular, have bought instruments linked to inflation so as to be able to meet their inflation linked liabilities. Many utilities around the world also require inflation hedging. The annual percentage price increases they negotiate with their regulators are generally a few percentage points above or below inflation. But inflation risk is no longer taken very seriously given that inflation around the world has fallen to levels of half a century ago.

And finally …

The main risks managed by derivatives are currency, interest rate, equity and commodity risks. But there are infinite varieties and combinations of risks than can be derived. Appendix 1 of the book "Key financial instruments: understanding and innovating in the world of derivatives" contains a comprehensive list of risk types, many of which can be managed by using financial derivatives. Some of the risks listed in the appendix arise through the use or abuse of financial instruments.

"50 Ways to lose your money"