Corporate treasurers are usually concerned about risk, and often have a mandate from their companies to measure and mitigate it. The importance of this mandate is evidenced by the amount of material published every month, encouraging treasurers to adopt different approaches and use different instruments.
The main problem with risk mitigation is that there are many different kinds of risk. Any attempt to remove all risks is likely to be prohibitively expensive, and so it is useful to look in detail at how to classify and view these risks. At a basic level, there are two different measures of any risk:
- How likely is the situation to occur?
- What would the impact be if the risk became a reality?
Every risk mitigation instrument and approach carries a cost, and this cost is usually calculated by reference to these two different dimensions.
When deciding on a risk management strategy, the treasurer must therefore decide what view they take of this interplay of factors to help them to analyse the most economically efficient approach. Different companies have different needs, but the following points may be useful when making the appropriate analysis:
- Risks with potentially catastrophic impact may be the ones which keep the treasurer awake at night, but they are often the ones which are least likely to occur. It might be better to concentrate on scenarios which are more likely to actually happen.
- Some risks with the most significant possible consequences may, in reality, only happen if the normal rules of business break down. For those with long memories, this was the case when Sterling left the ERM in 1992. Although the price of Sterling dropped, the market collapse was so bad that most foreign exchange providers stopped providing liquidity to the market and any attempt to reduce losses was useless because there was a shortage of institutions to deal with. It may not be worth protecting against these risks – the impact would be much wider than might appear to be the case, and the overall commercial damage to a firm might be a lot wider than can be hedged.
- At the other end of the scale, there are some risks which are very likely to materialise, but their impact would be very small and the exposure event happens frequently. In these situations, it may be worthwhile to leave the risk uncovered since the small potential loss is likely to be made up over time buy other counterbalancing events.
Different companies have different risk appetites and, indeed, face different risk scenarios. The above points suggest that treasurers should first of all start looking at their mid-level risks, and then work outwards, individually examining each risk type and scenario and deciding on whether it is economic to buy protection.
Download our guide where we examine different types of risk and explore specific hedging approaches.