concise guide to treasury risk mgmt final

7/31/2019 Concise Guide to Treasury Risk Mgmt FINAL

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Concise guide to

treasury risk management


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ABN 50 084 642 571 The Institute of Chartered Accountants in Australia Incorporated in Australia MembersLiability Limited. 0710-18AUS

The Institute of Chartered Accountants in Australia (the Institute) is the professionalbody representing Chartered Accountants in Australia. Our reach extends to more than

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We aim to lead the profession by delivering visionary leadership projects, settingthe benchmark for the highest ethical, professional and educational standards, and

enhancing and promoting the Chartered Accountants brand. We also represent theinterests of members to government, industry, academia and the general publicby engaging our membership and local and international bodies on public policy,government legislation and regulatory issues.

The Institute can leverage advantages for its members as a founding member ofthe Global Accounting Alliance (GAA), an international accounting coalition formedby the worlds premier accounting bodies. With a membership of over 800,000, theGAA promotes quality professional services, shares information, and collaborates oninternational accounting issues.

Established in 1928, the Institute is constituted by Royal Charter. For furtherinformation about the Institute, visit charteredaccountants.com.au

The Institute of Chartered Accountants in Australia

Disclaimer

As with any publication of this nature, the information contained in this publication is of a generalnature and should not be used or relied upon as a substitute for detailed advice or as a sufcient ordenitive basis for formulating business decisions.

The Institute makes no warranty as to, and accepts no responsibility for, the accuracy, adequacy

or completeness of any material contained in this publication or its suitability for use in particularcircumstances. Additionally, the Institute disclaims all liability to any person in respect of anything,and of the consequences of anything, done or omitted to be done by any such person in reliance,

whether wholly or partially, upon any information presented in this publication.

The Institute of Chartered Accountants in Australia 2010

First published August 2010

Published by: The Institute of Chartered Accountants in Australia

Address: 33 Erskine Street, Sydney, New South Wales, 2000

Concise guide to treasury risk management

First editionISBN 978-1-921245-61-9


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Foreword

Risk management continues to be an evolving and valued practice. The events of

recent years with the effects of the global nancial crisis have clearly shown the

importance of well developed risk management strategies and processes.It is in this regard that the Institute of Chartered Accountants in Australia (the

Institute) has developed this thought leadership initiative entitled, Concise guide

to treasury risk management. This guide is aimed at the senior management

and audit committee level and will assist these groups recognise and ask the

appropriate questions when they are addressing nancial risk instruments within

their own organisation.

This guide is the second in a series designed to assist Directors and Audit

Committees meet their responsibilities. This plain English guide, assists inthe understanding of an organisations treasury functions and is directed to

non-nancial institutions.

Experience has shown that treasury functions full an important part of an

organisations operations. However, at times it can be an area due to its nature

and complexity, that does not receive sufcient governance attention. The

Institute believes this guide will facilitate the communication and governance

of the Treasury functions.

I trust that you will nd this guide useful and practical in your organisationsunique risk management needs.

Michael Spinks FCA

PresidentInstitute of Chartered Accountants in Australia


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Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Identifying risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

The role of the Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Market risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Operational risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Contents


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Overview

This guide is designed to assist members of audit committees of non-nancial

institutions to full their governance roles. It addresses some of the key issues

surrounding the major nancial risks facing an organisation, as well as the use ofnancial risk instruments.

This guide will discuss risk management issues associated with the treasury and

nancial instruments used by an organisation to manage interest rate and foreign

exchange risk.

While this guide does not directly address commodity and energy risks for

audit committees, the risk issues are the same as for foreign exchange or

interest rates.

Risk or compliance?Risk management is not compliance; compliance is what you do to meet

regulatory or statutory legislation. Risk management is what you do for the

benet of your organisation. Risk management should add value to your

organisation at all levels; otherwise it is not maximising its value.

Most organisations, including not-for-prot and smaller nancial institutions,

consider themselves in a low nancial risk environment because they do not

speculate. While this may lead to smaller volumes of nancial instruments

compared to large trading organisations, the nancial risks of these instrumentsare the same. One of the biggest areas of nancial risk applies to the purchasing

and selling of nancial instruments, including derivatives, whether they are used

to trade or hedge a position.

Every audit committee must understand the importance of a suitable risk

management framework for their organisation.

Financial risks are a necessary part of every organisations nancial operation,

large or small, public or private. These risks include:

Market>

Credit>

Liquidity>

Operational.>


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This guide examines these risks. Depending on the risk appetite of the

organisation, it may wish to increase them, eliminate or even share them

with a nancial institution.Financial instruments can be used to reduce or hedge some market risk and to a

lesser extent credit and liquidity risks. Be aware, though that the use of nancial

instruments will in turn create operational risks.


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Identifying risk

Why does an organisation use these products?>

Are they the appropriate products?>

These are two fundamental yet very important questions senior managers andaudit committee members must be able to answer.

Financial instruments have an important role to play within any organisation

so audit committee members should be aware of and understand the need for

their use. For instance, borrowing in USD is considered risky for AUD revenue

companies. However, if they sell their goods in USD a natural hedge is often

created. If this happens it can help to limit the USD currency risk.

In considering when to use nancial instruments, some important questions

must be asked.

What are the organisations nancial objectives?>

What impact will the nancial exposure have on prot?>

What will be the nancial impact on prot, cash ow and dividend?>

Will these positions need to be hedged or are there offsetting exposures to>

limit/negate the position?

What will hedging actually achieve?>


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The role of the Board

Good risk management starts with the organisations Board setting appropriate

risk management and treasury policies. The Board must take an active interest

in those treasury activities, as well as the products in which the treasury deals.Boards are also responsible for deciding on the organisations risk appetite and

for communicating those risk policies to all employees. An organisations risk

policies and appetite can be hard to dene; therefore, the Board often nds this

a difcult area to manage.

Questions for the audit committee points to consider

Has the Board established an internally consistent and clear risk management>

policy, including risk limits appropriate to the risk appetite of the organisation?

Have appropriate limits and authorities been approved?>

Have risk management objectives and policies been approved by the Board>

and communicated to all staff?

Are management strategies and implementation policies consistent with the>

Boards authorisation?

Does senior management have a good understanding of the organisations>

nancial risk activities and treasury operations?

Are senior managers involved in setting policies for treasury and risk>

management goals?


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Market risk is usually dened as the movement in value due to a change in

price, creating a positive or negative value for the organisation. However, most

organisations consider this variability in price to be undesirable and prefer tolock in a known exchange rate or cost. Organisations can do this by buying

all their foreign goods and services in the domestic currency and letting other

entities handle the risk. Alternatively, an organisation may choose to take no

cover or handle the risk itself through the use of currency instruments. Currency

instruments used include forward foreign exchange (FX), foreign currency

options or combinations of both.

Many organisations make decisions to hedge all known exposures by the use

of forwards. However, while this may provide certainty it does not allow for the

opportunity of taking advantage of favourable moves in the exchange rate.

Although usually perceived as being too expensive, FX options are a better

alternative, especially if bought or quoted during times of high volatility of the

exchange rate. They allow full exibility of movement in the exchange rate while

protecting the organisation from any exchange rate downside. Consider these

products in the same way as car and house insurance. Purchasing FX options

may be considered as nancial insurance. The best outcome is when you dont

exercise your option, as this means the exchange rate has moved in your favour.

Some organisations may choose to remain unhedged during a nancial year.

For instance, several mining companies prefer to remain unhedged in both their

currency and commodity exposures.

When an organisation borrows from off-shore, cross-currency swaps may be

used. Cross currency swaps allow both the foreign currency and the interest rate

to be locked in.

Each organisation must consider its alternatives and attentively compare

its risk appetite with stakeholder expectations. These issues must be fully

communicated especially if any change of policy is proposed and/or it will have a

large impact on potential prots.

Interest rates are considered differently, as they are generally based on more

long-term up and down movement in interest rate trends. Most organisations

borrow money on a oating basis against a bank bill swap reference rate (BBSW)

or a bank benchmark. They look to x interest rate costs over a three to ve

year term, depending on their view or debt prole. The preferred instruments

for xing an interest rate are interest rate swaps and interest rate options. Caps

are interest rate options that protect the borrower from increasing interest rates,while oors protect the investor from falling interest rates.

Market risk


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Are risks identied as early as possible to ensure adequate steps are taken to>

handle the exposure in a timely manner?

Do risk measurement methodologies measure the risks adequately and in a>

timely manner?

Are potential stress tests and what if analyses undertaken monthly (eg.>

measuring sensitivity of exposure to market risk [VAR] and scenario analysis)?

Is there a suitable mix of oating and xed interest rates?>

What is the foreign exchange risk hedging policy?>

What percentage of foreign exchange is hedged?>

Is the audit committee informed of any breaches of market risk policy or limits?>


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Credit risk, often called counter party risk within wholesale markets, is the risk

that your counter party defaults before or on settlement date. Organisations

must judge this risk when dealing with nancial institutions and other corporateclients. Counter party risk is usually handled by reviewing the credit limits

published by the rating agencies where each nancial institution is given a credit

limit based on the published rating:

AAA rating $100 million limit>

AA rating $50 million limit>

A rating $20 million limit.>

How these limits are determined is usually based on an analysis of each nancial

institution and the Boards risk appetite, rather than a detailed credit study ofeach organisation.

Trading nancial instruments through a licensed stock or futures exchange

means counter party risk is almost negligible, because the clearing house

guarantees performance of the contract.

On the other hand, using over-the-counter instruments means you would be

trading with major banks, investment banks and other institutions that have

credit limits with your organisation. Unfortunately, it is very hard to estimate the

credit risk of these organisations to your organisation.Part of counter party risk is settlement risk, which is the risk that the

counter-party will default on the day of settlement particularly when it comes

to foreign exchange settlements. Also carefully consider if you pay or receive

collateral from a counter party (collateral may be used when you have limited

credit lines with a counter party). If collateral is necessary, ensure you have

appropriate policies in place with regard to the management and recording of

such collateral.

Credit risk also includes country/political/sovereign risk. This risk coversgovernments legislative change and is usually beyond the control of either party.

Credit risk


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What processes are in place to determine credit limits?>

Is there adequate capacity to measure credit exposure?>

Does the organisation have a process for handling and valuing collateral>

received or paid?

Does the organisation have settlement limits?>

What reliance is placed on credit ratings provided by a credit rating agency?>

Is credit risk appropriately managed?>

Is the audit committee informed of any breaches of credit or settlement>

limits immediately?


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Liquidity risk covers two important risks. It covers the risk of not being able to

deal in a market due to lack of liquidity, and funding risk, which is not having

adequate funds in place when they are needed. For most organisations usuallythe larger of these two is funding risk.

Many organisations manage funding risk by developing detailed cash ows for

a rolling 12-month period. Detailed cash ows are critical for the survival of the

organisation and must be continually updated based on current factors and

realistic assumptions.

Using nancial instruments can add to further volatility on cash ow, such as

when exercising an option. Locking in an exchange rate using currency forwards

may help reduce this volatility.To mitigate funding risk a detailed nancing plan is usually developed, on a

yearly basis at least.

When developing the plan consideration must be given to ensuring diversied

sources of currency and funders, as this will help in times of a major nancial

downturn in any single market. All organisations should run various risk

scenarios that consider potential adverse conditions and whether further

emergency funding lines may be needed.


What processes are in place to measure liquidity risk?>

What impact do nancial instruments have on cash ow?>

Are appropriate cash limits in place?>

Are secured funding lines in place?>

What level of security do these funding lines have?>

Is close contact kept with funders, shareholders and bankers?>

Are there diversied sources of funds?>

Is there a spread of products and maturities so that maturities do not build up?>

Is there liquidity in all the various nancial instruments eg. any exotic or>

structure products?

What stress scenarios are run and are they stressful enough?>

Is the audit committee informed of liquidity stress issues in a timely manner?>

Liquidity risk


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Operational risk is the most varied of the major risks. It is usually dened as

loss due to failure of people, processes and systems, or an external event such

as re, fraud, ood, earthquake or other natural phenomenom. For accountantsand nance professionals, operational risk also includes accounting and

valuation risk, issues that are vitally important for any organisation when nancial

instruments are used.

Operational risks are managed by having relevant policies, detailed procedures

and most importantly, well-trained and experienced staff.


Are all staff who are responsible for monitoring derivative transactions well>

trained and qualied?

What is the culture of staff and management toward risk and controls?>

Have staff adequate expertise for the roles that they perform?>

Are bonuses paid based on the results of any risk management or>

treasury activities?

Is there an independent system for calculating and reporting to calculate and>

report results?

Are treasury operations handled by internal staff with the appropriate>

treasury skills?

Are front and back ofce systems adequate and appropriately segregated>

to ensure the completeness and accuracy of processing, settlement and

verication of the value of outstanding transactions?

Are valuation and spreadsheet models independently reviewed?>

Are all back ofce staff adequately trained and do they understand the>products used?

Are the organisations systems capable of producing adequate disclosure>

information for users of the nancial statements?

Are accounting results routinely calculated and regularly reported?>

Do the external auditors have a clear understanding of their role in verifying>

the nancial transactions?

Are the policies and procedures reviewed at least annually?>

Operational risk


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The reporting of risks is crucial to the management of risk within any

organisation. It is important to set reporting benchmarks as early as possible to

ensure targets are relevant to outcomes. Reports must be clear, concise, timelyand relevant, and must provide a complete picture of the organisations nancial

risk in a format that can be used and understood by senior management and

the Board. So that the required decisions can be made, senior management and

the Board must feel secure about the provided information. For instance the use

of graphs rather than absolute numbers is a clearer way of showing reporting

trends. Depending on the needs of the organisation, some risk reports will be

on a daily basis, usually market risks and counter party reports, while others are

more appropriate as weekly, monthly and quarterly reports.


What nancial gains and losses does the organisation want reported on a daily,>

weekly and/or monthly cycle?

Is treasury performance appropriately measured and regularly reported?>

Are the treasury activities reported to senior management in a timely manner>

and in an appropriate format?

Is the organisational and reporting structure appropriate for ensuring that all> nancial risks are appropriately managed without internal conicts?

Are nancial risks clearly highlighted and monitored in Board and audit>

committee reporting?

Are key risk changes clearly highlighted?>

Are future possible risks considered within the reporting format?>

Are reports audited yearly and reviewed by senior nance staff with>

relevant training?

Who independently monitors and reviews treasury reports?>

Reporting


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Glossary

BBSW Bank bill swap reference rate, used by the industry

as a benchmark for interest rate swaps and forwards

and oating rate notes.

Cross currency swap Long-term hedging deal that enables an organisation

to lock in both an exchange rate and an interest rate in

a foreign currency, again a great risk management tool.

Foreign exchange

forward

A foreign exchange deal due for settlement greater

than spot and most commonly used by organisations

for hedging their foreign exchange exposure.

Foreign exchangeoption

A transaction used to protect a foreign exchangeposition without locking in a forward rate, a very

useful hedging product.

Foreign exchange

swap

A transaction where the foreign currency is bought

and sold in the same deal for two different dates,

used to fund foreign currency bank accounts.

Futures Mainly used to manage interest rate risk or equity risk

on licensed futures markets or commodity risk on

global futures markets.

Interest rate option To manage an interest rate risk, a cap protects you

from rising interest rate costs used by borrowers, and

a oor protects you from falling interest rates, used by

investors. Like insurance a premium is paid upfront to

buy protection.

Interest rate swap Used by organisations to swap from a oating interest

rate borrowing to a xed interest rate borrowing,

usually over a three to ve year time frame.

Spot foreign exchange A foreign exchange transaction due for settlement in

two business days from deal date, the rate that is

most commonly quoted in the media and on screens.

VAR A widely used risk measure of the risk of loss on a

specic portfolio of nancial assets.


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NotesConcise guide to treasury risk management


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NotesConcise guide to treasury risk management


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