Table of Contents
Part 1: Intro ............................................................................................................................................. 3
1.1 Risk, Uncertainty & Risk Management .................................................................................................... 3
Starting exercise: ....................................................................................................................................................................... 3
Uncertainty ................................................................................................................................................................................ 3
Risk: No universal definition ...................................................................................................................................................... 3
Types of uncertainty .................................................................................................................................................................. 3
Overview of major risks: ............................................................................................................................................................ 4
Mini case on identifying risks: ................................................................................................................................................... 5
Evolution of Risk management: traditional to ERM .................................................................................................................. 6
What is the concept of ERM: ..................................................................................................................................................... 6
ERM is characterized by 5 dimensions: ..................................................................................................................................... 7
5 essential steps to be implemented in ERM: ......................................................................................................................... 10
ERM implementation: risk frameworks ................................................................................................................................... 11
Current major global risks: introduction ................................................................................................................................. 11
Current major global risks: 2022 ............................................................................................................................................. 12
Interconnectedness of risks ..................................................................................................................................................... 12
Excercises Part 1.1 ................................................................................................................................................................... 13
Case 1 : Integrating risk management -Lego ........................................................................................................................... 14
1.2 The value of risk management .............................................................................................................. 18
Starting exercise ...................................................................................................................................................................... 18
The value of risk management ................................................................................................................................................ 19
Modigliani-Miller (MM) world: the irrelevance of corporate risk management ..................................................................... 19
Frameworks and value of risk management ........................................................................................................................... 19
Managers’ perspective ............................................................................................................................................................ 20
Shareholders’ perspective ....................................................................................................................................................... 21
Stakeholders’ perspective : ..................................................................................................................................................... 24
Back to part 1.1: FROM RISK MANAGEMENT TO INTEGRATED RISK MANAGEMENT ............................................................. 24
Excercises Part 1.2 ................................................................................................................................................................... 25
Part 2..................................................................................................................................................... 26
2.1 Corporate interest rate risk management .................................................................................................... 26
Starting exercise ...................................................................................................................................................................... 26
Importance of interest risk management ................................................................................................................................ 26
Importance of interest rat risk management: Vestia .............................................................................................................. 26
International Parity Conditions................................................................................................................................................ 26
International parity conditions in equilibrium (approximate form) ....................................................................................... 27
Interest rates and exchange rates ........................................................................................................................................... 27
Interest rate parity (IRP) .......................................................................................................................................................... 30
Covered interest rate parity .................................................................................................................................................... 31
Covered and uncovered interest arbitrage ............................................................................................................................. 31
Prices and exchange rates (1) .................................................................................................................................................. 31
Future spot rate ....................................................................................................................................................................... 32
Forward rate as unbiased predictor for future spot rate ........................................................................................................ 32
Prices and exchange rates (2) .................................................................................................................................................. 33
International parity conditions: exercise ................................................................................................................................. 33
Corporate interest rate risk management.......................................................................................................... 34
Interest rate risk exposure....................................................................................................................................................... 34
Management of interest rate risk............................................................................................................................................ 35
Swaps ....................................................................................................................................................................................... 37
Mini case: Xerox and Unilever ................................................................................................................................................. 37
à LIBOR = floating rate ........................................................................................................................................................... 37
Exercise on the interwebs : ..................................................................................................................................................... 38
Interest rate future .................................................................................................................................................................. 39
Excercise Interest Future Rate ................................................................................................................................................. 40
Interest rate options ................................................................................................................................................................ 40
1
, Management of interest rate risk: Case .................................................................................................................................. 41
Case: Option 1: Swapping to fixed rates .................................................................................................................................. 42
Case: Option 2: cross-currency swap swapping to fixed rates in other currency ................................................................... 43
Empirical evidence ................................................................................................................................................................... 43
Part 2..................................................................................................................................................... 44
2.2 Corporate foreign exchange risk management............................................................................................. 44
2.2.1 Introduction & prevailing practices ................................................................................................................................ 44
2.2.2 Transaction exposure ..................................................................................................................................................... 50
2.2.3 Economic exposure......................................................................................................................................................... 62
2.2.4 Translation exposure ...................................................................................................................................................... 72
2.3 Corporate credit risk management........................................................................................................ 81
Getting Started Exercise .......................................................................................................................................................... 81
2.3.1 Concept of credit risk management ............................................................................................................................... 83
2.3.2 Business credit risk ......................................................................................................................................................... 84
2.3.3 Counterparty credit risk (CCR) ........................................................................................................................................ 92
Exercises, practitioners’ corner & active learning ................................................................................................................... 95
EXTRA : course on covid 19................................................................................................................................ 97
2
,Corporate risk management and option
techniques
Part 1: Intro
1.1 Risk, Uncertainty & Risk Management
Starting exercise:
• Carlsberg: offset in growing costs, cost might be related to your commodity risk (commodity risk refers to the
uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of
commodities) à the fact that prices of your inputs go up or that wages will increase, the costs are going up and for
that they pass on certain of these costs by increasing their price
• The only thing that they believe would be is that it will also affect your business risk, your demand, so they believe
because of this price increase and because of the elasticity that there will be a decrease in the volumes
• In this situation often a different policy for the premium brands and the common brands: for the premium brands it’s
often easier to increase the price because people want to stick to the brand that they know; but if you have products
where the brand is not such a trademark then it’s much more difficult to pass on the price to consumers
Uncertainty
• A state of not knowing whether a proposition is true or false.
• All future events have some intrinsic uncertainty.
Risk: No universal definition
= certain scenario, with a certain consequence and a certain probability. 2 enterprise risk management perspectives.
Risk is about the probability that a certain event will arise and the severity (= hevigheid) of that event à so these are 2 central
elements when you look at risks, what is the probability that a certain event will arise and what is the severity of that effect
• COSO : “risk is the possibility that events will occur and affect the achievement of objectives”
• ISO: “the effect of uncertainty on objectives”
Types of uncertainty
• No uncertainty
• Established uncertainty
o we know the consequences, we know the probabilities à risks we can manage well. There is still a degree of
uncertainty bcs we don’t know exactly what will happen, but we have a good idea what’s the likelihood that
this would happen and also what would be the consequences if that would happen
• Imaginable uncertainty
o we know the consequences, but not the probability à for example a fire. You could have got a good idea
what the consequences are but you might
not be so certain about the probability that
something would happen
• Unimaginable uncertainty
o we don’t know the consequences and we
don’t know the probabilities. We really
don’t see this on the radar, but when it
happens it normally can have very severe
consequences
3
, Overview of major risks: (can also be classified otherwise, eg: firm-specific,
industry-specific, ..)
• Financial risks
o Market risk
§ Risk of loss due to adverse movement in asset prices
§ Associated with interest rates, foreign exchange,
commodity and equity risk.
§ Market risk management has evolved significantly.
§ Example:
• devaluation, sudden drops in currency: This will
impact the business
• Ryanair: oil price changes, they tried to hedge.
à commodity risk: This impacted their profit.
o Credit risk
§ Customers’ or business’ credit risk: credit risk associated
with normal business activities, like trade credit à you
sell and buy products and you might have trade credit
that is associated with this transaction, this is your
business credit risk
§ Counterparty credit risk stemming from derivatives:
• Otc: over the counter: derivatives can be traded
on regulated markets, but the vast majority are
OTC’s: settled directly between trading room of
banks and big firms.
o Risk that the counterparty could default
to a derivatives transaction before the final settlement (eg default on outstanding
swap)
o Rapid development in derivatives markets in terms of growth and complexity has
increased credit risk and the need for more advanced risk management tools.
o Liquidity risk
§ Funding liquidity risk: Ability to raise the necessary cash to roll over its debt or meet its obligations
(payments, margins, ...).
• If you want to do that, you will have to at least have a notion about your cash inflows and
cash outflows at certain time periods
• If I look at today, what are the expected inflows and the expected outflows and do they
match or don’t they match; what will be the inflows and outflows next day, next week, next
month à if you see that the cash inflows and the cash outflows don’t match, then you can
think about other ways in order to limit the gap that we see there
o It could be for instance that you can need or lack certain cash inflows or cash
outflows, bcs maybe you have to pay some things but you also have 30 days in order
to do that, so you can move a little bit that payment in order to see whether they
match and if not then you might have to go to other techniques in order to limit
your liquidity risk
§ Asset liquidity risk: you want to trade, but is there a counterparty who’s interested? Risk that
transaction cannot be executed with the desired trade size and without generating a significant price
impact. à can lead to losses if the transaction cannot be postponed
• This is more in the financial markets’ context, suppose that you want to buy a stock or you
want to make a transaction that’s very large, that actually the trading in that financial
instrument is not liquid enough à so you cannot execute a transaction at once
• And bcs of that if the transaction has to be split into smaller ones, then you will have a price
impact à so you execute let’s say the first block of your transaction, but bcs on that moment
the demand is already higher than the supply, the price will rise
• So your 2nd block, you will not be able to execute that original price but at a slightly higher
price à this is what is called a price impact, bcs you want to execute this large trade but
actually it’s not liquid enough in order to do that
• When you look at liquidity risk, sometimes hard to judge bcs it’s very dynamic and you may
have situations which look very liquid, look very positive, but the liquidity can change rather
quickly
o And you are interested in having sufficient liquidity not in good times, but in bad
times
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